I am using Quickbooks Online:
I am a bit confused about my S-Corp Retained Earnings account. Does the balance of that account just continuously grow (or shrink if the business makes a loss) regardless of me taking distributions? I started my business in July 2020. I had $70,000 in sales. I paid myself W-2 wages of $12,500 ($25,000 annualized). My net income was $39,000. My contributions were $20,000. My distributions were $40,000. My total equity at year end 2020 was $20,000.
Now in 2021, my revenue was $65,000. I paid myself $25,000 W-2 wages. My net income was $20,000. I made no contributions. My distributions were about $23,000. My total equity at year end 2021 is $17,000. This all makes sense to me. Now, my net income gets booked to retained earnings, so my retained earnings now show at $59,000 as of Jan 1, 2022.
I guess I'm confused because I have taken most of the money out of the business through distributions or paying for business expenses. The cash balance in checking is only $6,000. Is there no relationship between making distributions from my s-corp and the balance in my retained earnings account? I always thought the retained earnings account was supposed to represent funds available to invest in the business or pay out as dividends, but it seems to me the only thing that will reduce the balance in that account is business losses. I read somewhere that the IRS doesn't like to see a big retained earnings balance in an S-corp or they might revoke its status. Please help to clear up my thinking. Does it really not matter what the retained earnings account balance grows to? Is it more important to look at the net of retained earnings (large positive balance) and Owner Investment (large negative balance)? Thanks!!
I have never heard that comment about how the IRS feels about retained earnings. As a pass through entity I can not see why they would care about the balance. The 2021 net profit is taxed to the shareholder(s) and adds to RE in 2022, so those funds are already taxed.
Technically there is no drawing and investment account in a corporation. If yo invest funds, that is a loan to the corporation (a liability account ) and you take distributions not draws. Distributions must be made equally to all shareholders, and normally are approved by a shareholders meeting or the board of directors. Distributions should be restricted to once a quarter though there is no hard rule to support that.
Ideally I like to see a high ratio of RE to total assets. To find the ratio divide the RE balance by the total assets. The higher the number the better IMO, it means that the company is more stable and able to finance itself going forward.
Owner investment you say is a large negative balance, if that is a liability account that is fine, if that is not a liability account something is wrong. Always look at the balance sheet for values NOT the account listing, the account listing can be confusing.
It sounds like you are the only shareholder, correct? My response below assumes you are. Keep in mind that, if there are additional shareholders, you must make distributions pro-rata to all shareholders so making distributions is not as straightforward.
Retained earnings are reduced by your distributions and net loss and increased by net income. It helps to set up a new equity account each year called, for example, 2022-Distributions. You record your distributions to that account throughout the year and then close it out to retained earnings at year-end (debit retained earnings, credit 2022-Distributions). Then, in 2023, set up a 2023-Distributions equity account and so on. Your distributions are reported on Sch. M-2 of the corporation's 1120-S, so it's nice to have a separate distribution account for each year that can be made inactive in QB after closing it out to retained earnings.
You have paid tax on every dollar in retained earnings, so the right balance to leave in there comes down to how you run the business. I have had discussions with other CPAs and most feel you should get as much of the retained earnings out of the business as possible, especially if you are the only shareholder. It's a legal liability in case of a lawsuit. You can take it out (you've already paid income tax on it) and put it back into the business at any point, so there's no need to leave it in there. You do not need to treat money put into your S-corp only as a loan, you can treat it as a loan (that requires a formal loan agreement), but you can also treat it as an owner's contribution. The main advantage to a loan is to be able to get your money back if there are multiple shareholders without making distributions to all shareholders. But, if you are the only shareholder, this is not an issue.
I have seen S-corps with millions in retained earnings, so I would not be too concerned about the IRS revoking your S-corp status. S-corps can be quite large.