When people hear the term earnings, they usually think of the money earned by an individual or company. For example, an employee earns money by selling products, providing services, etc. However, the retained earnings formula will calculate something else entirely.
Once a company deducts all the costs of doing business from its revenue, it can determine its net income, which is its bottom line. Companies then distribute some of those earnings to investors via dividends, and the remainder goes into the company’s retained earnings account for future use. Retained earnings can increase and decrease over time, depending on net income and distributions.
In the rest of this article, we’ll dive into the details of retained earnings. Specifically, we’ll cover the following topics:
- What are Retained Earnings?
- How Do You Calculate Retained Earnings?
- Does Net Income Affect Retained Earnings?
- Do I Have to Pay Taxes on Retained Earnings?
- Final Thoughts
What are Retained Earnings?
To explain retained earnings, we must first discuss net income. A company’s net income is its total revenue minus all costs of doing business. After subtracting these costs, the company has its bottom line or its net income.
Also, net income pertains to a specific period (e.g., quarterly or annual net income). Businesses also have retained earnings, which represent a cumulative total. More precisely, a company’s retained earnings are equal to its historical net income minus any distributions it pays to owners. In publicly traded companies, these distributions normally come in the form of dividends paid to shareholders. In privately-held companies, owners may classify them simply as distributions. Either way, the simplified retained earnings formula is:
Beginning retained earnings + current net income – current distributions.
The primary difference between retained earnings and operating earnings (or operating income) is their taxes. Generally speaking, operating income equals operating revenues (e.g. sales income) minus operating expenses. This total does not include taxes. Once a company pays taxes on its earnings, it arrives at its net income. And net income increases the retained earnings account, while owner distributions reduce the account.
Businesses can use their retained earnings for any number of items. Common uses include:
- Capital improvements
- Business expansion
- Taking advantage of new business opportunities
- Future owner distributions
How Do You Calculate Retained Earnings?
Remember, calculating net income and using the retained earnings formula is just basic addition and subtraction. For instance, assume a company has been in operation for five years, with $100,000 in net income each of those years and has had no distributions. The retained earnings at the end of the fifth year would equal $500,000 ($100,000 net income per year x 5 years). Now let’s say in the sixth year, the company earns an additional $100,000 and decides to make a $50,000 owner distribution. Retained earnings at the end of the sixth year would equal:
Year 6 = $500,000 beginning + $100,000 current net income – $50,000 current distribution
Year 6 = $550,000
In other words, at the end of the sixth year, this business has $550,000 in retained earnings to use however it sees fit.
Does Net Income Affect Retained Earnings?
Yes, net income directly affects retained earnings. As stated, net income pertains to a single period (e.g., a quarter or fiscal year). At the end of a period, the net income resets and the next period starts, creating a new measure of net income.
On the other hand, retained earnings serve as a way to measure a businesses’ success in a cumulative way. At the end of each period, net income (minus any owner distributions) closes into the retained earnings account. For example, assume a business has $250,000 in net income and issues $100,000 in stock dividends in a particular year. At the end of that period, the retained earnings account would increase by $150,000 ($250,000 in net income – $100,000 in stock dividends).
That said, a business loss can reduce your retained earnings account. Say, for instance, a business experiences a $50,000 loss in a given period. After that period, the business’s retained earnings account would decrease by that $50,000 loss.
Do I Have to Pay Taxes on Retained Earnings?
Businesses do not need to pay taxes directly on retained earnings. As stated above, net income includes taxes paid. Therefore, once your net income account shifts into retained earnings, you have already paid taxes on those earnings.
However, you may need to pay taxes depending on what you do with the underlying funds in your retained earnings account. For example, say that you have retained earnings of $100,000 in a low-interest savings account. If you collect $1,000 in interest on those funds in a given year, you must pay taxes on that income. From an accounting perspective, that $1,000 qualifies as non-operating income, but you still need to pay taxes on it.
Additionally, you may need to pay taxes indirectly on retained earnings distributions, depending on how you organize your company. The IRS considers corporations as separate taxable entities from their individual owners (i.e., stockholders). Accordingly, any future distributions made from a retained earnings account will incur taxes at the individual level. So investors must pay taxes on stock dividends, even though the business already paid corporate taxes on those earnings.
On the other hand, distributions from pass-through entities (e.g., sole proprietorships and partnerships) do not pay a separate business-level tax. Rather, the IRS taxes earnings on the owners’ personal tax returns. This refers to pre-taxed retained earnings that won’t be taxed again when distributed to owners.
Business owners need to remember that the retained earnings formula is essentially your accumulated net income minus any owner distributions. You can use these funds for any number of purposes, from future distributions to expanding your business.
While retained earnings can seem like a complicated topic, associated tax planning should not be a daunting challenge for small business owners. At Tax Hack, we live and breathe taxes for small businesses. So contact us today to set up a tax planning strategy session!