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What do retained earnings mean?
Retained earnings are what a business has left after setting aside money for dividends and taxes.
These funds are typically recorded on the company’s balance sheet, and they can be used to finance various areas of the business, such as purchasing new equipment, expanding operations, reinvesting in the company, or even paying debts.
The Internal Revenue Service (IRS) allows C corporations to retain up to $250,000 in profits each year without incurring any taxes on those profits. For businesses in specialized fields such as finance, actuarial science, engineering, architecture, counseling, healthcare, law, and the performing arts, the limit is US$150,000.
It is essential to thoroughly document your business plans and have them examined and approved by the board of directors, should the IRS require evidence for retaining funds.
Why does a C corp keep retained earnings?
To understand the reasons behind retained earnings, it’s important that you’re familiar with the term ‘double taxation’.
Double taxation is a reality for C corporations, as these entities must pay taxes on corporate profits, and then shareholders face additional levies when receiving dividends or withdrawing money from the company.
To avoid being taxed twice, many C corporations choose to retain their earnings instead of paying them out as dividends. By doing this, the corporation can reinvest its earnings and use them to finance growth, as well as build up capital to invest in other projects or opportunities.
There is a set cap on how much money businesses can keep in order to prevent the misuse of retained earnings for tax evasion, and they must provide evidence of their business use along with payment details if they exceed that limit.
When should a C Corp use retained earnings?
Retaining earnings can be useful for your C corp in certain circumstances. Let’s take a look at some of the situations where you may want to consider retaining earnings:
- Acquiring a different business
Your retained earnings can be the most effective way of financing a business expansion or an acquisition that is predicted to bring in more profits. Utilizing your company’s kept funds for this purpose allows you to further expand your business without additional outside investments.
- Raising working capital
Retained earnings are the perfect way to ensure your business has the necessary funds for day-to-day operations.
Investing in working capital with retained earnings can secure enough money to cover regular expenses, as well as help you manage sudden costs or plan ahead for future purchases.
Doing so will solidify your company’s financial footing and keep it running efficiently.
- Implementing growth strategy
You can use your retained funds to run projects or conduct research that will help drive future growth and development. Retaining earnings allows you to allocate resources to certain areas of the business and make strategic investments that can set your company up for success in the long run.
- Paying premiums for insurance
Retained earnings can come in handy when paying premiums for insurance policies, allowing you to pay the premiums without incurring additional debt and interest payments, making it easier to manage your company’s financials.
- Paying off debt
Retained earnings can also be utilized to settle debts with suppliers or other related companies. Doing so will not only help you pay off any outstanding debt but will also save you from paying high-interest rates and additional fees.
Additionally, if your company has taken out a loan to finance a project, using retained earnings to cover the occasional payment can help you manage your cash flow and make sure that you can pay off the loan on time.
Overall, retained earnings are a great way to provide a financial cushion for your C corporation, allowing it to secure its future with smart investments and long-term strategies.
Retained earnings vs Dividends – Which is better?
The decision between retaining earnings and paying out dividends to shareholders must be made on a case-by-case basis.
Retained earnings are generally more beneficial in terms of taxes, as they allow you to invest profits without incurring additional levies. Additionally, retained earnings give you more flexibility when it comes to financing projects and investments, as you can use these funds in any way that you choose.
On the other hand, dividends are more beneficial when it comes to increasing shareholder value, as they provide shareholders with a return on their investment. Paying out dividends also allows investors to benefit from capital gains taxes rather than regular income taxes.
There are specific times when shareholders may want the company to pay out dividends instead of reinvesting the earnings. For example, if the shareholders believe that the stock market is going to decline, they may want to receive the dividend so that they can invest the money elsewhere.
Ultimately, the decision will depend on the company’s goals and the expectations of your shareholders. It is always best to consult with a financial advisor before making any decisions in this regard.
Retained earnings are an important and powerful tool for financing a corporation, allowing it to make smart investments that can propel the company to greater heights. Understanding how retained earnings work will help you make more informed decisions about your company’s financials, ensuring its long-term stability.
Are you thinking about incorporating a C-corporation but have some questions? Simply type your inquiries into the chat box on the right and one of our experts will be more than happy to address them for you. We take pride in providing clear answers so that you can make an informed decision with confidence.
Frequently Asked Questions
Accumulated Earnings Tax of C corporation
The accumulated earnings tax is a tax imposed on C corporations that accumulate earnings beyond the reasonable needs of their business. The tax is designed to discourage businesses from accumulating earnings and profits for the purpose of avoiding income taxes.
The accumulated earnings tax is imposed at a rate of 20 percent of the accumulated taxable income.
*Accumulated taxable income = Taxable income – The dividends paid deduction – The accumulated earnings credit (which is Exemption levels – $250,000 or $150,000)
However, according to CFR 1.534-2 (d), you as a taxpayer are authorized to submit a statement within 60 days of receiving a notification to defend the alleged unreasonable accumulation.
Visit this official IRS website for further information.
Disclaimer: While BBCIncorp strives to make the information on this website as timely and accurate as possible, the information itself is for reference purposes only. You should not substitute the information provided in this article for competent legal advice. Feel free to contact BBCIncorp’s customer services for advice on your specific cases.
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