What Is Undistributed Income and How Is It Taxed?

Undistributed income is the portion of an entity’s profit that is not paid out to its owners or beneficiaries and is instead retained within the organization. This practice is common across various entities for numerous financial reasons. The tax implications of this retained income differ significantly depending on the structure of the entity holding the funds.

Corporate Undistributed Income and Retained Earnings

For C-corporations, undistributed income is known as “retained earnings.” This account represents the cumulative profits reinvested back into operations rather than distributed as dividends. This provides the internal funding required for growth and stability.

Companies retain earnings for “reasonable business needs,” such as financing expansion plans, research and development, debt repayment, or maintaining working capital. There must be a justifiable business purpose for not distributing the profits.

The Internal Revenue Service (IRS) recognizes valid reasons for accumulating income. However, retaining excessive income without a documented, reasonable business need can lead to scrutiny. This is to prevent using the corporate structure to shield shareholders from personal income taxes.

The Accumulated Earnings Tax

If the IRS determines a C-corporation is holding earnings beyond its reasonable business needs, it can impose the Accumulated Earnings Tax (AET). This penalty is asserted by the IRS, typically after an audit, to discourage corporations from being used to avoid personal income tax on dividends.

The tax rate for the AET is 20 percent, equivalent to the top tax rate on qualified dividends. This rate is applied to “accumulated taxable income,” the portion of the current year’s retained earnings deemed excessive.

Corporations can accumulate a certain amount of earnings without justification under the accumulated earnings credit. For most C-corporations, this credit is $250,000. For personal service corporations in fields like health, law, and consulting, the credit is $150,000. Any accumulations above these thresholds must be supported by documented business needs.

Taxation in Pass-Through Entities

The tax treatment of undistributed income in pass-through entities, like S-corporations and partnerships, is different from C-corporations. These entities do not pay income tax at the business level; instead, financial results are “passed through” directly to the owners. This structure eliminates the possibility of an accumulated earnings tax.

Each owner receives a Schedule K-1, which details their proportional share of the company’s income, losses, and credits. The amounts from the Schedule K-1 are reported on the owner’s personal income tax return, ensuring all profits are taxed at the owner’s personal rates.

Owners are taxed on their share of the entity’s income regardless of whether they receive any cash distributions. For example, if a partnership retains all its profits for expansion, the partners are still liable for income tax on their shares. This requires owners to pay taxes on “phantom income” they have not received in cash.

Undistributed Income in Trusts and Estates

For trusts and estates, undistributed income is governed by a metric known as Distributable Net Income (DNI). DNI is a calculation that determines the maximum income a trust or estate can pass through to its beneficiaries. This figure limits the trust’s distribution deduction and the income beneficiaries must report.

If a trust distributes income, it receives a tax deduction for that amount, and the beneficiaries pay the income tax on the distributions. This income is reported to beneficiaries on a Schedule K-1 (Form 1041) and is taxed at their personal rates.

If a trust retains income, it is considered undistributed net income (UNI), and the trust itself must pay the income tax on this amount. Trust tax brackets are highly compressed, meaning undistributed income can reach the highest marginal tax rates at much lower income levels than for individuals. This makes retaining income within a trust potentially tax-inefficient.