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Volume 14 Issue 4

July/Aug 2002

Corporate Retained Earnings

© by Tax & Business Professionals

Most people like making money and hate paying taxes. What about those who make money and pay tax twice? Impossible, you say? No, not if the taxpayer is a C corporation. A regular, or C, corporation is a corporate entity that pays tax as opposed to those pass-through entities such as S Corporations, Partnerships, and Limited Liability Companies (LLCs).

If a C corporation makes a profit, it has to pay tax on the profit. Certain big corporations, such as WorldCom, strive mightily to show earnings with no apparent concern about paying tax. Smaller companies are in a different game. Reported profits result in retained earnings, a type of equity. As years roll by, these accumulated after-tax earnings increase the retained earnings account, unless they are distributed.

Retained earnings in a C corporation will eventually be taxed again, either as dividends, salary, bonuses or as liquidating dividends when the corporation is terminated. Of these four choices, the most favorable is a distribution of salary and bonuses, which are deductible as compensation at the corporate level, although they are subject to additional employment taxes. Dividends, as most know, are not deductible at the corporate level and are often frowned upon in smaller entities for their lack of deductibility.

Zeroing Out

Many small to medium corporations “zero out” their earnings. Zeroing out means to claim salaries and bonuses, plus other deductions, that significantly reduce the annual profit (retained earnings) of the corporation. In case of the need for liquidity, the amounts taken as salary and bonus can be loaned back to the corporation. Such loans should be documented with corporate minutes and promissory notes with reasonable rates of interest, often the Applicable Federal Rate.

It is a good idea when forming an entity, or when doing long-range planning for potential profits, to document in the minutes resolutions for bonus plans for the officers of the corporation so that, if later, officers' compensation is attacked by the IRS as being too high, there is a documented basis for the deductions for bonuses, unless the bonuses are proportional to stock ownership.

There is another retained earnings problem that is 180 degrees different from an IRS attack on excessive officer compensation. If a corporation unnecessarily accumulates retained earnings, there is a special, somewhat punitive, tax called the Accumulated Earnings Tax which imposes a special tax on the corporation if it has what are deemed to be excessive earnings. This tax can be avoided by distributions of earnings in the form of dividends, or, within reason, as bonuses by following the method suggested above of documenting bonuses to officers. Retained earnings in excess of $250,000 should be justified.

Another way of justifying accumulated earnings is to show through corporate minutes that there is a future need for such retained earnings; for example, building a new factory, introducing a new product line, or having a cash reserve for an expected business downturn. Unfortunately, corporate managers often do not become aware of a potential accumulated earnings tax liability until the issue is raised in an audit.

The ability of the IRS to tax the corporation for accumulating too much retained earnings and, conversely, to attack the corporation for distributing too much in the form of deductible compensation, leads to the need for planning.

Why Does it Happen?

 We run across quite a few cases in which there are large retained earnings in small to medium-sized C corporations. Many shareholders are oblivious to the potential problems, while their accountants, who are often retained only for tax return preparation and are not asked to do corporate planning, overlook the problem.

There is a natural reluctance of small corporations to reduce costs by not seeking the advice of professionals. In such cases, although the shareholders and principals allow retained earnings to accumulate, feeling that they have strengthened their corporate entity by creating a large pool of retained earnings, in reality, the wisdom of accumulating earnings that will be taxed twice is often questionable.

If you have further questions about this subject and the need for appropriate minutes, contact The Tax and Business Professionals.

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Published jointly by The Tax & Business Professionals, Inc. and the law firm of Newland & Associates as a service to their clients.

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