Retained earnings (RE) are the total profits a company has kept over time instead of paying them out to shareholders. These funds are either reinvested in the business or reserved for future needs. RE are commonly associated with businesses structured as corporations or LLCs, whereas sole proprietorships and partnerships generally do not maintain a retained earnings account.
Key takeaways:
- RE shows how much profit a business has kept over time, not just what was earned in a year.
- A high RE balance doesn’t mean there’s a lot of cash in the bank — it could be tied up in assets or receivables.
- RE are recorded in the equity section of the balance sheet and typically have a credit balance.
- Corporations must watch their RE levels since exceeding $250,000 (for C-corps) or $150,000 (for professional service corporations) without a valid reason can trigger a 20% accumulated earnings tax from the IRS.
Retained earnings formula and example
In computing RE, we use the following formula:
RE, ending = RE, beginning + Net income − Dividends
- RE, beginning is the balance of RE from the prior period that was carried forward to the current period.
- Net income is the results of operations during the current fiscal or calendar year. It can also be a net loss if the business had more expenses than revenues.
- Dividends are distributions of earnings to the stockholders, whether cash or stock dividends. It is only deducted from RE when it is declared.
To illustrate, let’s assume the following information from Magenta Corporation:
- Retained earnings, 1/1/2024: $2,892,500
- Net income during 2024: $275,321
- Dividends declared on 12/1/2024: $85,721
Retained earnings, 1/1/2024 | $2,892,500 |
+ Net income during 2024 | $275,321 |
− Dividends declared | $85,721 |
= Retained earnings, 12/31/2024 | $3,082,100 |
Journal entries
In the books, the journal entries to record net income and dividends are as follows:
Date | Account | Debit | Credit |
|---|---|---|---|
Dec 1 | Retained earnings | 85,721 | |
Dividends payable | 85,721 | ||
(To record dividends declared) | |||
Dec 31 | Income summary | 275,321 | |
Retained earnings | 275,321 | ||
(To record net income during 2024) |
Notes:
- In the first entry (Dec 1), I debited RE because dividends are a distribution of profits. Hence, I need to reduce RE by the amount declared as dividends.
- In the second entry (Dec 31), I credited RE because the company generated a net income for the year. The income summary account is a temporary account used to close the income and expense accounts during period end.
- Therefore, RE has a normal credit balance because crediting the account increases its balance while debiting it does the opposite.
Advanced concepts in retained earnings
There’s more to RE than meets the eye — it is not simply a holding account of all the company’s profits. Beyond tracking profits, it also absorbs adjustments from past errors, changes in accounting methods, and specific corporate allocations.
- Prior period adjustments: When the business commits a mistake or omits a transaction from previous years, it is required to make a prior period adjustment to correct those errors. Since previous years’ books have already been closed, the adjustment or correction is made in the current period and the net effect of the adjustment is absorbed by RE.
Examples of prior period adjustments:
-
- Accounting errors, e.g., omission (not recording a transaction), commission (recording $1,000 as $100), principle (recording expense as asset), transposition (recording $335 as $353), and arithmetic errors
- Change in accounting principle, e.g., from FIFO inventory to LIFO inventory
- Change in accounting estimate, e.g., from straight-line depreciation to double-declining depreciation
- Appropriation: There are some instances where corporations are required to set aside a portion of RE for specific reasons, such as
- Contractual appropriation wherein the corporation must set aside RE to comply with a loan covenant, sinking fund, or bond redemption fund
- Voluntary appropriation for business expansion, emergency reserves, or any legitimate business purpose
Tax implication of retained earnings
The tax implication of RE depends if you’re an S-corp or a C-corp.
- An S-corp is a pass-through entity, so it doesn’t pay corporate income tax. Instead, all profits flow to the owners’ personal tax returns, whether or not they actually take money out of the business. So if the S-corp’s net income is $50,000, the whole amount goes to RE. The bad news is, owners get hit with 15.3% self-employment tax. However, reducing the impact of self-employment tax is possible with a reasonable salary for an S-corp shareholder.
- A C-corp pays corporate income tax at 21%. Hence, the net income that goes to RE is net of the income tax. For instance, if the net income is $200,000, what goes to RE is only $158,000 ($200,000 × 79%?) less dividends declared, if any. On top of that, shareholders will shoulder taxes on dividends if the corporation decides to pay dividends.
Aside from tax status, accumulated earnings tax might affect RE. When a C-corp excessively retains too much earnings, the IRS penalizes it by imposing a 20% tax on accumulated earnings.
Here’s how it works.
- The IRS uses a reasonableness test to check whether the corporation’s RE is reasonable.
- If the amount of RE exceeds $250,000 (for most businesses) or $150,000 (for professional service corporations), the amount in excess is considered unreasonable and is subject to 20% penalty tax.
- The corporation may make a case with the IRS and explain that excess RE is being held for legitimate business purposes — such as business expansion, debt repayment, or contractual obligations.
Why corporations retain earnings
Many business owners find RE a bit tricky to grasp because it’s not always clear whether it represents actual money the business can use. For example, if your RE shows $500,000, does that mean you have that much cash sitting in your bank account? Not necessarily.
The rationale behind RE lies in the business judgment rule, a corporate doctrine that protects a corporation’s decisions from legal scrutiny — as long as they are made in good faith and in the best interest of the company. This principle supports the retention of profits for several key reasons.
- Business stability: If the corporation keeps on distributing profits to the shareholders, it would affect business stability due to constant outflow of resources.
- Business growth: Reinvesting the profits is additional new capital to the business, which could be used for facilitating growth and development in different business areas.
- Cushion against risk: Unexpected costs and losses can impact the financial position of the business. Having RE can mean that the business has enough reserves to absorb the impact of these losses without affecting working capital, operations, and company valuation.
Frequently Asked Questions (FAQs)
No. Profit is the result of operations during the current financial year, while RE are profits that have accumulated throughout the years less dividends declared and paid.
Yes, as it is a sign that the business is accumulating profits.
Yes, but only by declaring dividends, which is a corporate action. Only the corporation’s board of directors can declare dividends. And due to the business judgement rule, the board may opt not to declare dividends regularly.
It affects taxes in two ways. First, it depends on your tax status. S-corps don’t pay income taxes, so RE is the gross of corporate income tax; meanwhile, C-corps pay corporate income tax of 21%, and dividends of stockholders are also liable to pay dividends tax. Second, accumulating too much RE can result in accumulated earnings tax, a 20% penalty tax for corporations that excessively retain too much earnings.
Bottom line
RE shows the amount of earnings accumulated throughout the years less dividends paid to stockholders. However, corporations must take note that holding too much RE can trigger a 20% accumulated earnings tax — unless they can justify to the IRS that holding excessive RE is for a legitimate purpose. On top of that, C-corps must remember that earnings are taxed twice: once at the corporate level (corporate income tax) and again at the stockholder level (dividends).
