Our team of business experts will explain the definition of retained earnings on this page. Then, you can explore all our products and services to help you manage your legal compliance.
Retained earnings mean a company’s earnings remaining in the business after paying shareholder dividends. A small business owner might encounter retained earnings when accounting for income and paying taxes. Only corporations (and LLCs electing corporate taxation) will have retained earnings. For LLCs and partnerships taxed as “pass-through entities,” the business passes its income to the owners and does not pay dividends.
Retained earnings matter in corporate taxation. When a corporation makes a profit, the Board of Directors has a choice. They can distribute the surplus to the shareholders or retain it for the company to use in the next accounting period. When the corporation issues dividends, its shareholders pay a dividend tax on that income. If the corporation chooses to have retained earnings, the income becomes taxable equity at the end of the accounting period.
Retained earnings can be considered deferred dividends or money the company reinvests for long-term shareholder benefit. Like all corporate income, retained earnings are subject to double taxation. First, the corporation will pay corporate income taxes on its revenue. Then, when they receive dividends, the shareholders pay dividend taxes at a rate up to 28%.
On the other hand, shareholders do not pay taxes on retained earnings because they never receive them. Instead, the IRS allows a corporation to retain up to $250,000 for the reasonable needs of the business. If a corporation retains income “beyond the reasonable needs of the business,” it will owe an accumulated earnings tax of 20%. A business owner will likely pay a lower tax rate on dividends than the corporate rate on retained earnings.
Retained earnings can act as an indicator of financial strength because the value transfers from previous years. However, shareholders might consider a high amount of retained earnings to signify that the company should pay more dividends. To preserve shareholder loyalty, business owners should pursue profitable growth opportunities. According to the IRS, reasonable retained earnings are backed up by specific, definite, and feasible plans for their use.
When you’re searching for the retained earnings business definition, you’ll likely come across these terms:
These various terms all refer to retained earnings, meaning the money returning to the company’s balance sheet for the next accounting period after paying dividends.
To calculate your company’s potential retained earnings, consider this formula: Retained earnings = Beginning Period Retained Earnings + Net Income (or Loss) − Dividends
As an example, imagine you started your business on January 1, 2020. Because you’ve just started, your earned income is $0. The business earned $1,000 in net income in January. On February 1, you decide to pay dividends totaling $500. Thus, on February 1, the company’s retained earnings are $500 ($0 + $1,000 – $500 = $500).
Remember that a corporate board member owes a fiduciary duty to the company. They must consider the company’s best interests when deciding whether to maintain retained earnings or pay dividends.
The retained earnings definition represents the revenue reinvested in the business at the end of an accounting period. The corporate board of directors pays a surplus to the shareholders as dividends or keeps the money as retained earnings.
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Disclaimer: The content on this page is for information purposes only and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.
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