As a startup begins to make money, often the disposition of the entrepreneurs is to reinvest profits back into the business. It is the prudent financial choice. Profits that are kept in the business for purposes of future growth are “retained earnings.”
Retained earnings can have tricky tax implications for startups. For instance, if your startup made $1M of revenue on $700k of expenses (not including founder’s compensation), it had a $300k profit. But the founders may only take home half of that amount. Say for example there are two founders, they would each take home $75k in the year and each leave $75k in the startup to ensure the startup’s future growth. The money left in the business is retained earnings.
If the money left in the business is not spent within the tax year, it is counted as profit and flows through to the founders on their K-1’s as profits and taxed as if the founder had received that money personally.
So in the hypothetical example above, instead of the two entrepreneurs having $75k each on their taxes (which is the amount they personally took home), they would each have $150k on their taxes. So they would have to be prepared to pay more taxes than anticipated from their take home amounts.
Historically, in our business we have decided it fair to help our founders pay the additional taxes incurred by retained earnings with additional disbursements from the company to the founder. In order to compute how much help the company would be willing to provide, the founder computes the amount of taxes they owe with and without the retained earnings on their K-1. The difference is what the company helps the founder pay.
It is important to understand and anticipate the impact of retained earnings on founder’s salaries and have a set plan for handling those situations when the need arises.
What are your thoughts on retained earnings and taxes?