Avoiding Accumulating Excess Retained Earnings

A company faces the possibility of having issues with the Internal Revenue Service scrutinizing them with regards to the retained earnings. Retained earnings could be perceived as being excessive related to the capital needs of the company. A solution is needed that addresses finding the most tax efficient way to maximize shareholder value. If the sole proprietorship was converted to a C Corporation, they would be able to better maximize the profits that they end up with.

            A company is limited to the amount of retained earnings that it can keep in the company because the IRS wants to prevent corporations from sheltering or sparing shareholders from paying income taxes that they would pay on earnings that are distributed. Because there is a maximum amount of retained earnings that are allowed to be kept on a balance sheet, excess retained earnings have to be distributed to the shareholders of the company. There are several ways that a C Corporation can go about distributing earnings without having to be excessively taxed on those distributions (IRS, 2011).

C Corporations generally only use a few methods of extracting capital from the corporation. Salaries and bonuses of the company would immediately become tax deductible and would minimize the tax burden to the company. However, if the salary is deemed excessive for the work being done by the IRS, the tax deduction is disallowed.

            C Corporations can pay out cash dividends to their shareholders. The owner of the company would be the exclusive holder of all of the shares of the company. Because the dividend that is being paid out is post-tax money, they qualify for the 15% tax bracket under the Bush Tax Cuts. This is going to save a lot of money because the top tax bracket for income earned is as high as 39.6%. 

            The Bush Tax Cuts were recently extended by President Obama through the end of 2012, when the previous 2001 tax rules will go back into place. This is known as the sunset provision. To utilize the maximum benefit of the Bush Tax Cuts, a large amount of retained earnings should be distributed prior to the expiration. I would recommend cutting retained earnings by half and distributing the other half and have that half subject to the 15% tax bracket. It is always possible that these tax cuts could once again be extended to last a longer period of time as opposed to expiring in 2012. Legislation should be carefully monitored to assure that they are going to expire or be extended.

            If they are going to be extended, the company should only distribute what they have to in order to not be subject to the penalties that are imposed on companies that retain excessive amounts of earnings in the company. The action plan for the company in between now and the dividend payment time should involve following the new on the possibility of Bush Tax Cuts extension. When the legislation is passed, cash should be raised in the corporations brokerage account and match gains to losses. Next, the company will have to examine the shareholders passive loss situation. Near the end of the year, a meeting will have to convene to announce the declaration of an appropriate extra dividend.

            This strategy creates a timeline for reducing retained earnings in 2012 based on whether or not the Bush Tax Cuts are extended. The company is going to be able to save much more money if they classify themselves as a C Corporation instead of a sole proprietorship because of the taxation rules for each corporation. It outlines what the board member are going to have to watch out for and the actions that they are going to need to take in regards to whether there is an extension or not. There must be effective communication as to what is going on with the legislation and everyone is going to need to be well informed so that the proper steps can be taken.

IRS. (2011). Sole Proprietorships. Retrieved from http://www.irs.gov/businesses/small/article/0,,id=98202,00.html.