When a business keeps a portion of its net income, rather than paying out that portion as a dividend, it has retained earnings. The normal purpose of retained earnings is to expand the business by financing the purchase of additional property, equipment or labor. The Internal Revenue Service taxes retained earnings under certain conditions.
While accountants speak of retained earnings, the IRS prefers the term "accumulated earnings." The IRS does not object to a company keeping a portion of net income, as long as the retained earnings are used for "bona fide" business purposes. However, the IRS does not want companies to retain earnings just to avoid paying dividends or other distributions that are taxable to the company's shareholders. If the retained earnings accumulate to an unreasonable extent, in the view of the IRS, an accumulated earnings tax comes due.
The IRS guidelines treat $250,000 in retained earnings as a reasonable limit for most businesses. For service-related businesses in accounting, engineering, health, law or architecture, the standard falls to $150,000. If your company's retained earnings surpass the limit, you must show a bona fide business purpose for the excess.
Your company has to show plans for expansion or new investment if it passes the IRS accumulated earnings limit. Other acceptable uses for retained earnings would be to pay taxes, to pay attorney fees for litigation, to redeem stock shares or to retire outstanding debt. To prove a bona fide business reason, however, you would need to furnish meeting minutes, memoranda, plans, letters, emails, invoices, sales orders or other documents proving that the money is needed and used for business expansion.
Companies declare retained earnings on their business tax returns. If the IRS decides that a business has excess earnings, the company will be liable for income tax on that amount at the rate of 15 percent, with interest calculated from the date of the return. A common way to avoid the payment of this tax -- which applies to C corporations -- is to offer a year-end bonus to corporate officers, a special distribution to partners or a special dividend to company shareholders.