Tax on Retained Earnings C Corp: Everything You Need to Know
Tax on retained earnings C corp is a common question for those in the process of incorporating a business.3 min read
2. How Are Retained Earnings Used and Reported?
3. Why Do Corporations Retain Earnings?
4. What Is the Accumulated Earnings Tax?
Updated October 15,2020:
Tax on retained earnings C corp is a common question for those in the process of incorporating a business. C corporations are subject to double taxation because profits are taxed at the corporate level when they are earned and at the individual level when they are distributed as dividends. Other business entities, including partnerships, limited liability companies, and S corporations, only pay income tax at the individual level. However, C corps are not taxed on earnings retained to reinvest in the company.
How Do Retained Earnings Work?
After paying its bills and debts and distributing profits to shareholders and owners, the C corporation can invest the remaining funds in the company. This reinvested amount is a type of equity called retained earnings.
Corporations are required to pay income tax on their profits after expenses. If no profit is recorded, no income tax is paid. Retained earnings can be kept in a separate account and are tax-exempt until they are distributed as salary, dividends, or bonuses. Salary and bonuses can be deducted from corporate income tax, but are taxed at the individual level. Dividends are not tax-deductible.
Retained earnings are most often used to purchase supplies and equipment needed for the company, as well as other expenses and assets. These saved funds are known as accumulated retained earnings and are listed as stockholder equity in the company's balance sheet.
How Are Retained Earnings Used and Reported?
Corporations must publish a quarterly income statement that details their costs and revenue, including taxes and interest, for that period. The balance shown on the statement is the corporation's net income for the quarter and is considered accumulated returned earnings. This account is the only available source for dividend payments, but a company is under no legal obligations to pay these earnings to shareholders as dividends.
An annual report will indicate the retained earnings year-end balance, as well as the changes in this balance, over the course of the year.
Retained earnings can be spent on reasonable business needs, which may include, but are not limited to:
- Acquiring another company
- Expanding operations
- Increasing working capital
- Paying off debt
- Paying insurance premiums
- Making loans to customers and suppliers
Retained earnings cannot be used to make loans to shareholders or their friends and relatives or to make investments that are not associated with the business.
Why Do Corporations Retain Earnings?
If shareholders do not need immediate cash, they may vote to retain corporate earnings to avoid income tax. As retained earnings increase, the stock value of the company also increases. This allows shareholders to later sell the company at a higher price or they can simply withdraw dividends in the future. Retained earnings also allow investment in the growth of the business.
Earnings cannot be retained for the sole purpose of tax avoidance; a corporation that does so may be subject to either a personal holding company tax or a penalty tax. This rule also applies to a controlled corporate group, which could have either a parent-subsidiary relationship (parent corporation owns at least 80 percent of voting shares) or sibling subsidiary relationship (more than 50 percent of the voting shares are held by fewer than five shareholders).
Companies can avoid these penalties by paying out a certain amount of dividends within 2.5 months of the end of the tax year in question.
What Is the Accumulated Earnings Tax?
This tax can be assessed by the IRS on accumulated retained earnings that have not been earmarked for a clear purpose. Private and publicly held corporations are subject to this tax, but it does not impact passive foreign investment companies, tax-exempt organizations, and personal holding companies.
For C corporations, the current accumulated retained earnings threshold that triggers this tax is $250,000. This is because corporations that do not spend retained earnings are generally more valuable than those without accumulated retained earnings. This decreases government tax revenues because shareholders are unlikely to sell their valuable shares and be subject to income tax on the sale.
Corporations who do not have an approved explanation for retaining earnings over this threshold may be levied a 20 percent tax on funds exceeding $250,000.
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