Do You Pay Taxes on Retained Earnings?

Retained earnings reflect a company’s decision to reinvest profits back into its operations rather than distributing them to owners. Many individuals inquire about the tax implications of these accumulated profits. This overview clarifies how profits that become retained earnings are treated for tax purposes, depending on the business structure and subsequent actions.

Understanding Retained Earnings

Retained earnings are the cumulative net profits of a business that have not been paid out as dividends to shareholders. They are a component of a company’s equity on its balance sheet, representing the portion of profits kept to fund future growth or operations. Retained earnings are calculated by taking a company’s net income and subtracting any dividends paid. Companies use retained earnings for reinvestment in new projects, expansion of existing operations, or to pay down debt. They also provide a source of working capital, bolstering a company’s financial stability and enabling it to weather economic fluctuations.

Taxation of Business Profits

Business profits are subject to taxation at different stages, depending on the legal structure of the entity. For C corporations, profits are taxed directly at the corporate level. The federal corporate income tax rate is a flat 21% for tax years 2024 and 2025.

In contrast, pass-through entities, such as S corporations, partnerships, limited liability companies (LLCs) taxed as partnerships, and sole proprietorships, are not subject to income tax at the entity level. Instead, profits generated by these businesses “pass through” directly to the owners’ personal income tax returns. Owners then pay individual income tax on their share of the business’s profits, regardless of whether the profits are distributed to them or retained within the business. Federal individual income tax rates for 2024 range from 10% to 37%, depending on taxable income and filing status.

Retained Earnings and Corporate Income Tax

Retained earnings in a C corporation represent profits already subjected to corporate income tax. After a C corporation calculates its net income and pays federal corporate income tax, the remaining after-tax profits can be distributed as dividends or retained within the business. Therefore, these retained earnings are not taxed again at the corporate level.

Retaining earnings allows a company to fund internal initiatives without incurring additional corporate-level tax on the retained amount. This avoids immediate taxation at the shareholder level that would occur if the earnings were paid out as dividends. Shareholders will face tax implications when these earnings are eventually distributed or realized.

Taxation Upon Distribution or Sale

While retained earnings are not taxed a second time at the corporate level, they become taxable to individuals (shareholders or owners) when realized or distributed. This occurs through dividends. When a corporation distributes retained earnings as dividends to shareholders, they become taxable income.

The tax rate on dividends depends on whether they are classified as qualified or non-qualified. Qualified dividends, which meet specific IRS criteria such as holding period requirements, are taxed at preferential long-term capital gains rates: 0%, 15%, or 20%, depending on the shareholder’s taxable income. Non-qualified dividends are taxed at the shareholder’s ordinary income tax rates, which can be as high as 37%.

Another way retained earnings can lead to taxation for individuals is through the sale of a business or stock. When an owner sells their shares in a corporation, the value of the accumulated retained earnings often contributes to the overall sale price of the company. Any profit realized from this sale, representing the difference between the sale price and the original cost basis of the shares, is considered a capital gain.

Long-term capital gains, from assets held for more than one year, are typically taxed at the same preferential rates as qualified dividends: 0%, 15%, or 20%. This taxation is on the increased value of the ownership interest, not a direct tax on the retained earnings themselves.

Accumulated Earnings Tax

The Internal Revenue Service (IRS) imposes the Accumulated Earnings Tax (AET) on C corporations under certain conditions. The AET is a 20% penalty tax applied to corporations that accumulate earnings beyond the reasonable needs of their business. Its purpose is to discourage corporations from retaining excessive profits to avoid individual income tax on dividend distributions. This tax applies in addition to regular corporate income tax.

Generally, a C corporation can accumulate up to $250,000 in earnings without triggering the AET. For personal service corporations, this threshold is $150,000. Accumulations exceeding these amounts must be justified by the “reasonable needs of the business” to avoid the tax. Such reasonable needs can include financing for business expansion, acquiring another business, paying down debt, or providing working capital. The IRS requires specific, definite, and feasible plans to justify these accumulations.