Reinvesting in your business is essential to helping it grow, but shareholders also expect a return on their investment in the organization. How businesses distribute profits among shareholders and assume tax responsibilities on retained earnings will depend on a number of factors, including the amount of retained earnings and your organization’s expenses. Because these factors can change over time, it’s best to work with a New York accountant who has experience with state and federal tax law.
LLCs as Pass-Through Entities
An LLC, or limited liability company, is a hybrid entity that has characteristics of a corporation and a partnership. According to the IRS, it can be treated as either kind of business for tax purposes, depending on whether you opt to file a Form 8832 and affirm your organization’s status as a corporation. Otherwise, an LLC is a pass-through entity, which means that profits and tax liability “passes through” the business to be distributed among owners and shareholders.
Sometimes it’s preferable to allow tax liability to pass through to individual returns; at other times, you may want to file corporate taxes. Where this distinction matters most is with retained earnings.
Retained Earnings and Taxation
Retained earnings are what you have left for reinvestment in the company after subtracting dividends from the LLC’s total net income. This retained surplus that isn’t distributed to partners and shareholders is subject to taxation. If your organization’s retained earnings reach a $250,000 threshold, any amount beyond this becomes subject to a supplemental corporation tax at 39.6 percent. For example, if your LLC ends the fiscal year with $400,000 in retained earnings, $150,000 of that amount is taxed at the supplemental corporate rate for a tax liability of $59,400.
Under normal circumstances, then, it is often best to limit retained earnings and let revenue pass through unless you are able to justify a significant reinvestment of profits. The IRS makes exceptions on supplemental tax liability when businesses demonstrate how they plan to use these retained earnings.
Justification of Retained Earnings
A business that plans to expand, upgrade equipment, or invest in restocking inventory can offer a business justification for using retained earnings and may be able to waive additional taxes. You will need to document how you plan to allocate retained earnings. Your CPA can offer guidance on how to gather and prepare the necessary proof, which might include meeting minutes, quotes for services, and other evidence that your LLC is preparing for growth.
Form 8832 and Corporate Taxes
Another way to manage retained earnings is to file a Form 8832 and affirm your choice to have corporate taxes assessed on your LLC. For companies that intend to invest retained earnings into the organization over a few years, this may be a fiscally sound choice, but because you must wait five years before returning to a pass-through taxation structure, you will want to go over all your options with your accountant.