Understanding S Corp Retained Earnings

Are you looking at Schedule L of your S Corp’s Form 1120S and wondering why your S Corp's retained earnings don’t match the retained earnings on your financial statements? And what should retained earnings on an S Corp's tax return look like anyway? It’s a common question, but don’t worry, we’re going to break it down for you

Let’s start with Schedule L on the 1120S Tax Return.

Schedule L is where you report your S Corp's balance sheet exactly as it appears in your financial records. This section follows standard accounting rules, so it shows your company's true financial picture, not the numbers adjusted for your S Corp tax return.

By the way, this is how Schedule L looks and I even located retained earnings on it for you:

 The key thing to understand here is that S Corp retained earnings on your tax return should come directly from your financial records.

How to Calculate S Corp Retained Earnings

Now, once you understand the main logic behind  Schedule L, let’s look at the formula for S Corp retained earnings. As you can see, it’s pretty easy to grasp:

Retained Earnings = Beginning Retained Earnings + Net Income (or Loss) − Dividends Paid

Let’s break that down:

1. Beginning Retained Earnings: This is the rolled-over amount of retained earnings from the previous year.

2. Net Income (or Loss): This is the book profit (or loss) the S Corp earned during the year.

3. Dividends Paid: Oops. S corps don’t really pay dividends. Cross out word "dividends" and write down "distributions" instead. In an S Corp, distributions to shareholders are usually tax-free up to the shareholder’s stock basis.

   
   

Please note: additional shareholder contributions are not included in this formula and are shown somewhere else on the S Corps Schedule L.

As we can see from the formula, retained earnings is the profit the S Corp has earned but hasn’t paid out to shareholders yet. Instead, these earnings are reinvested in the business or held for future use. It’s important to remember that this number on Schedule L reflects your financial records, not tax adjustments.

Let’s follow an example here (see the picture above):  If your S Corp started the year with $100,000 in retained earnings, earned $40,000 in net income, and paid $10,000 in distributions, the retained earnings on the S Corp tax return at the end of the year would be $130,000  Do you see a reconciliation of retained earnings anywhere on the S Corp tax return? Nope, not really. That's why it's important to keep this formula in mind.

Does that mean that your financials will also show 130K of Retained Earnings? Not necessarily. Sometimes, you need to do some accounting "magic" and rearrange numbers so that they match the retained earnings on the S Corp return.

For example, depending on the setup of the chart of accounts in your accounting software, your accounting financials may have a different formula for retained earnings. This happens a lot in our practice with small S Corps. For example, clients' financials may not include distributions into their retained earnings, or everything is lumped into one equity account. In this case, we will have a problem of mismatching financials vs. the tax return.

To fix this problem, CPAs rearrange balances on the balance sheet by using the formula mentioned above and arrive at the new number for retained earnings. Some CPA firms do not adjust clients’ books at all and just save copies of their work for their own records, using these workpapers to transfer the new adjusted financials into the S Corp returns. At our CPA firm we adjust the corporation’s retained earnings to match the presentation of Schedule L so it is easier to work with financials going forward.

How to Reconcile S Corp Retained Earnings

When you’re working on your S Corp tax return, the rule of thumb is to always check the S Corp’s retained earnings from the previous year. This is important because any errors or changes in your books can affect the current year’s numbers.

Once you've confirmed that the previous year’s retained earnings are correct, check the current year’s number on Schedule L to see if it matches your current books. If they don’t match, it’s time to do some detective work.

Here are a few things you could look at:

• Make sure you're using the right accounting method—accrual or cash basis.

• Check for any errors in transferring data from your financial records to the tax return.

Final Thoughts:

You need to understand a formula of your S Corp's retained earnings if you preparer your personal S Corp tax return. Retained earnings on your tax return come straight from your financial records and follow a simple formula: starting retained earnings + net income or loss − distributions. To avoid mistakes, always double-check your retained earnings and make sure they match the numbers on your tax form. And if you still can't figure it out, please contact us! We've helped many S Corp owners with their accounting problems. You can check out our services here.