Are Retained Earnings Taxable? A Look at How They Are Taxed

Companies often generate profits, and businesses frequently choose to keep a portion within the company instead of distributing all profits to shareholders. These retained profits are known as retained earnings. Business owners and investors often wonder how these accumulated funds are treated for tax purposes. This article explores how retained earnings can be subject to taxation at both the corporate level and for individual shareholders.

Understanding Retained Earnings

Retained earnings represent the accumulated net income of a company that has not been distributed to shareholders as dividends. They appear on a company’s balance sheet as part of equity. The calculation involves taking net income for a period and subtracting any dividends paid out during that same period.

These earnings serve various purposes as a source of internal financing. Companies might use retained earnings to fund expansion projects, like opening new locations or developing new products. They can also be used to pay down existing debt, strengthening the company’s financial position. Retaining earnings also allows a company to build cash reserves for future needs.

Corporate Level Taxation

Retained earnings themselves are not subject to a separate, direct tax once they are retained. Instead, the net income from which these earnings originate is taxed at the corporate level. For C-corporations, this means the company’s profits are subject to federal income tax, currently at a flat rate of 21%, and potentially state income taxes before any portion becomes retained earnings.

A specific tax, known as the Accumulated Earnings Tax (AET), can be imposed on C-corporations that accumulate earnings beyond the reasonable needs of the business. This tax, outlined in Internal Revenue Code Section 531, discourages companies from hoarding profits to help shareholders avoid individual income taxes on dividends. The AET is a 20% tax on “accumulated taxable income” and applies if the IRS determines the accumulation is primarily for tax avoidance.

Shareholder Level Taxation

Retained earnings are not taxed at the shareholder level until they are either distributed or the shareholder realizes value from them. One primary way shareholders realize value is through dividends. When a corporation distributes a portion of its retained earnings as dividends, these distributions become taxable income for the individual shareholders.

Dividends can be classified as either qualified or non-qualified, which affects their tax treatment. Qualified dividends are taxed at lower long-term capital gains rates, ranging from 0% to 20% depending on the shareholder’s income bracket. To be considered qualified, dividends must meet certain criteria, including being paid by a U.S. or qualified foreign corporation, and the shareholder must meet a specific holding period. Non-qualified dividends, also known as ordinary dividends, are taxed at the shareholder’s regular ordinary income tax rates, potentially reaching 37%. These include dividends from entities like Real Estate Investment Trusts (REITs) or Master Limited Partnerships (MLPs), or those that do not meet the holding period requirements.

Another way shareholders can realize value from retained earnings is through an increase in the company’s stock value. As a company retains and reinvests earnings, its overall value can grow, which may lead to an appreciation in its stock price. If a shareholder later sells their stock for more than they paid, the profit is taxed as a capital gain. This capital gain is subject to either short-term or long-term capital gains rates, depending on how long the stock was held.

Specific Scenarios for Businesses

Closely held businesses, often having a small number of shareholders, face particular scrutiny regarding the Accumulated Earnings Tax (AET). The IRS may view excessive retained earnings in these companies as an attempt to avoid individual income taxes on dividend distributions for the owners. To avoid the AET, these businesses must demonstrate that their accumulated earnings are for the “reasonable needs of the business.” Documenting these needs through board minutes, business plans, or financial statements is important.

The tax treatment of earnings also differs between C-corporations and S-corporations. C-corporations are subject to corporate income tax on their net income before any earnings are retained or distributed. In contrast, S-corporations operate under a “pass-through” taxation model. This means an S-corporation’s income, deductions, losses, and credits are passed directly to its shareholders and reported on their individual tax returns, regardless of whether the income is distributed or retained.