Corporate Retained Earnings: Your Company’s Emergency Savings Account
Date: 02-24-2009
By Thomas E. Vass - The Private Capital Market, Inc.

By Thomas E. Vass
President, The Private Capital Market, Inc.

Part of the The Business Capital Advisor Business Investment Series

Introduction: Does Your Company Have an Emergency Savings Account?

One of the common financial planning rules for families is to adopt a family budget and dedicate 10% of every paycheck to the family emergency account. Part of the idea is to also adopt rules and procedures for what event constitutes an emergency.

Otherwise, there may be miscommunication between spouses about the sudden withdrawal of funds for an emergency shopping event.

The same advice about following a written budget and saving for an emergency also works for companies. The legal form of the company, (S- corp. C corp, LLC) affects some tax considerations of this account, and your tax advisor can help you work through the issues to minimize any tax obligations.

The main idea is to open a separate account at a financial institution, and dedicate 10% of top line revenues to the account every month. From an accounting point of view, the funds in the account will be characterized as “retained earnings,” and the account would be called your “retained earnings account.”

The most important part about opening and managing a retained earnings account is maintaining written documents on how the funds are to be used and minutes from board meetings showing authorization from the Board of Directors to use the funds.

Retained Earnings: Documenting Your Business Judgment

For many years, Microsoft held over 43 billion in retained earnings and went for decades without ever paying a dividend.

Here is how the retained earnings appear on a recent MicroSoft annual balance sheet financial statement:

Stockholders' Equity
Misc Stocks Options Warrants - - -
Redeemable Preferred Stock - - -
Preferred Stock - - -
Common Stock 62,849,000
Retained Earnings (26,563,000)
Treasury Stock - - -
Capital Surplus - - -
Other Stockholder Equity - - -

Total Stockholder Equity 36,286,000

Stockholders' equity has two primary components:

• Contributed Capital (Capital Stock which is the investment capital contributed by the original owners);
• Retained Earnings shows the company's accumulated net income or loss, less cash dividends paid, plus or minus prior period adjustments from the date that the corporation began to the present. Reported profits result in retained earnings, a type of equity. As years roll by, these accumulated after-tax earnings increase the retained earnings account, unless they are distributed.

If a company showed on the balance sheet 10% in Contributed Capital and 90% in Retained Earnings, it would indicate that most of its stockholders' equity came from retained profits. This is important because most high tech companies finance innovation and growth from their own internal sources of capital.

The most common distinction made about retained earnings concerns whether the funds are unappropriated or appropriated

Some decisions in tax court determined that the only retained earnings that could be subject to tax would be "those held for no reason" or the "unappropriated" retained earnings.

The appropriated retained earnings have corporate documents, prepared using “business judgment” on how the funds would be used.

How Are They Taxed?

The premise behind the federal government retained, or accumulated, earnings tax is that companies that retain earnings typically experience higher stock price appreciation. Although this is beneficial to stockholders, as capital gains taxes are lower than dividend taxes, it is detrimental to the government because the government can not obtain taxes as long as they are sitting inside the company account.

In order to speed up tax payments, the government uses a negative incentive (a large stick) to persuade companies to issue dividends to shareholders, thereby allowing the government to collect from the stockholders.

If a C corporation makes a profit, it has to pay tax on the profit. Then, if it does not pay out its retained earnings, it may be taxed on the value of the account. This large negative incentive tax is called the Accumulated Earnings Tax.

Generally, but not always, the threshold value for imposing the tax is around $250,000, unless the company can document its business judgment for using the funds.

How Are They Used

One way of justifying accumulated earnings is to show through corporate minutes that there is a future need for such retained earnings;

·
• building a new factory, ·
• introducing a new product line, or ·
• having a cash reserve for an expected business downturn, ·
• or issuing Treasury stock to valued employees or otherwise raising capital for the company.

Another technique for accessing the funds is via loan agreements between the company and the owners of the company. In this case, the funds from the account are paid out to the owners in the form of compensation, and the owners execute a loan back to the company.

Tax and legal advisors are required to help implement this loan strategy. The transaction must be approved by the Board of Directors and documented with corporate minutes. The loan must be evidenced by written promissory notes with reasonable rates of interest, often the Applicable Federal Rate.

Why They Are Valuable When The Company is Sold or the Company is Raising Capital

In an exit event of the early investors involving the sale of the company, the retained earnings become a valuable source of funds for the original shareholders. Often, those funds can be used as a special bonus to the original owners. The use of the funds must be documented in the minutes resolutions for bonus plans for the officers of the corporation so that, if later, officers' compensation is attacked by the IRS as being too high, there is a documented basis for the deductions for bonuses.

The agreement and documentation would contain text such as the value of the account, and the authorization to issue a promissory note to the shareholders, prior to the effective date of the sale.

The retained earning can also be distributed in the form of stock dividends. Stock dividends are distributions of the company's own stock and are usually for less than 25% of its total shares. The shares are valued at their FMV.

Sometimes, when new equity owners are being brought on as investors, the retained earnings can be distributed in the form of Treasury stock. Treasury stock are shares previously issued and then, bought back by the company and held on the books as Treasury stock.

How To Manage The Retained Earnings Account

The funds should be segregated from other cash accounts, and held in an account titled “Retained Earnings Account,” which was authorized by the Board of Directors. In the minutes of the Board meeting authorizing the opening of the account, the minutes would describe the business judgment of using the funds, and what events would constitute an emergency.

The funds should obtain professional management by an outside investment manager, whose performance is periodically reviewed by the Board of Directors, who would set the Investment Policy Statement for the manager to follow.

Most Investment Policy Statements would include the asset allocations for the funds, and the range of acceptable securities to be bought.

In most cases, the securities would include very safe, high dividend paying stocks, that would be eligible for the “dividends received exclusion” available for most corporations. In other words, if the corporate retained earnings are invested in dividend paying stocks, the government provides a tax break on those earnings.

A paradoxical, but welcome, outcome for having a corporate emergency savings account.

About Our Guest Columnist:
Tom Vass is a registered investment advisor, money manager, and insurance advisor for small companies. He is licensed in all areas of life, health, disability, property and casualty insurance. His areas of expertise include technology stock investments, based upon his proprietary and patented investment methodology, helping companies raise growth capital, and devising strategies to use company-owned insurance to help owners obtain a better retirement. His website for business owners is www.businesscapitaladvice.com. He can be reached at 919 975 4856 or tvass@privatecapitalmarket.com. Thomas is also founder of the RTP Innovation Business Development Network held at the BNC in Cary, NC. For more background information and links to related websites, check out Thomas' Archives as well as all our other guest columns

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