When a business is operated through a legal entity like a corporation or limited liability company, the revenues from business operations go into the accounts of the company before being distributed to the owners. The money that stays in the company’s accounts and is neither distributed to the owners nor spent on expenses or investments is called retained earnings. Retained earnings are not the same as profits or net income, even though they are similar. Money retained in the corporate accounts without a reasonable business purpose are potentially subject to a penalty tax at the corporate level or individual level, depending on the business form.
Penalty Tax vs. Income Tax
The Internal Revenue Service taxes corporations on their retained earnings by what is called the accumulated earnings tax. This tax is separate from the corporate income tax that is paid on each year’s profits. The accumulated earnings tax is a penalty tax paid by corporations whose retained earnings are judged by the IRS to be unreasonable and unrelated to bona fide business needs. The IRS' reason for this tax is to discourage business owners from using corporate accounts to avoid personal income taxes. For example, if money were kept in the corporate account but the owners took low-interest loans from the company, the IRS may judge that these funds are retained earnings and subject to a penalty tax.
Reasonable Business Needs
The IRS recognizes that companies need to keep a reasonable amount of cash in their accounts to cover cash flow needs, save for expansion or reserve for other reasonable business needs. For the retained earnings account to qualify as a reasonable business need, the corporation must have specific, definite and feasible plans for the money. The IRS will look for certain red flags -- a lack of regular distributions of profits to shareholders or distributions characterized as loans to shareholders, for example -- that suggest the money is being retained for improper purposes. However, an actual attempt or plan to invest in expanding the business will generally prevent the application of the penalty tax.
Calculating the Tax
The accumulated earnings tax is determined at the end of each tax year. In calculating whether earnings are subject to this tax, federal income tax payments, distributions to shareholders, capital gains tax and other deductions are subtracted from the total earnings. Against the remaining earnings, a normal C corporation gets a credit, called the accumulated earnings credit, of $250,000; only retained earnings in excess of $250,000 are potentially subject to the penalty tax. For service corporations, whose principal function is performing accounting, legal, architectural engineering or health services, the credit is only $150,000. The excess is taxed at the current rate of 15 percent.
S Corporations and LLCs
Entities that use the pass-through tax system, such as S corporations and limited liability companies that choose to be taxed as partnerships, are not subject to the accumulated earnings tax. However, the owners of these businesses are responsible for paying taxes on profits that stay in the company on their personal taxes. The IRS regards all profits in an S corporation or LLC to be distributed to the shareholders in accordance with their percentage ownership, and therefore the owners will have to pay personal income tax on their share of the earnings that remain in the company, even if they did not receive a distribution.