Accumulating Cash in a Subchapter S Corporation

There are good reasons to let cash build up in the account of a small S corporation. The money could be used to buy equipment or expand the business. There are no rules that prevent the accumulation of cash, but the way an S corp works concerning income taxes could result in a cash squeeze for the owners if the company is very profitable and retains lot of cash instead of distributing it.

The unique feature of S corporation election compared to a regular C corporation is that the S corporation does not pay income taxes. Net profits or losses are passed through to the S corp shareholders, who claim their proportional share of the corporate results on their personal income tax returns. An S corporation stockholder pays income tax on his share of the company's earnings, whether or not the company has paid out cash to the shareholders or retained the money.

The board of directors of the S corporation decides what to do with the money the company generates. A common practice is to pay some or a large portion of the net cash generated to the owners as dividends. For a small business, the dividends paid may be a significant portion of an owner's earnings or compensation. However, the board is not required to pay a specific percentage or all of the net income as dividends.

If the board of directors -- which may be the owners of a small S corp -- decides to keep the cash in the business, the money would become an asset of the company. Since the company profits are taxed at the ownership level, there are no tax problems with keeping the money in the company's bank account. From a strategy point of view, your business may decide to retain cash as a cushion for a variety of reasons to allow the company to generate even more profits in the future.

The major potential problem with retaining cash in the S corporation arises if the owners have to pay large tax bills based on the corporate earnings they must report on their own taxes. The ownership could be put in a bind if the company does not distribute at least enough cash to cover the taxes that must be paid. Investor-owners may want to see some return on their investment after tax and be expecting a larger dividend payment.