An LLC refers to a limited liability company. In this type of corporate structure, the individual shareholders are not personally liable for the company's debts. Profits of an LLC are generally distributed to the shareholders in the same fashion as a general partnership. Any profits that are not distributed at the end of the LLC's tax year are considered retained earnings. The IRS has specific rules that pertain to the tax treatment of excess retained earnings. Once retained earnings hit a certain threshold, the excess accumulation can be taxed unless the corporation can justify the accumulation.
How Retained Earnings Works
Like a partnership, an LLC records its income and expenses and then passes the net profit or loss to the individual shareholders based on the shareholders percentage of stock ownership. A 60 percent shareholder would receive 60 percent of the net profit. This profit distribution is shown on a K-1 form which is issued by the corporation to the shareholder. The distribution is not subject to payroll taxes and is recorded as other income by the individual who receives it. An LLC does not have to distribute all of its net profit. Any undistributed profit is shown on the books as retained earnings.
Tax on Accumulated Retained Earnings
If an LLC doesn’t distribute all of its earnings to its shareholders, it could be liable for a supplemental corporation tax on any amount retained over $250,000. The tax rate on this excess accumulation is 39.6 percent. For example, if an LLC shows $300,000 retained earnings at the end of its fiscal tax year, $50,000 would be subject to the supplemental tax. This would result in a tax of $19,800 ($50,000 times 39.6 percent.)
Exceptions to Retained Earnings Tax
The IRS permits exceptions to the retained earnings tax, but a corporation will need to show there is a business justification for the retained earnings. For example, if an LLC is planning on expanding during the next tax year, they may need excess cash for increased payroll or to acquire new machinery and equipment. In this case, the corporate minutes would need to demonstrate that an expansion is in the works. The IRS might request a copy of the board minutes as justification for the accumulation of retained earnings.
Since the tax on undistributed retained earnings is substantial, management should plan in advance for the proper treatment of the retained earnings. It is usually advisable to distribute any retained earnings to individual shareholders since the tax rates for individuals is below the 39.6 percent rate assessed on an LLC retained earnings.