Question

Compare the characteristics of a general partnership, limited partnership, regular C corporation, subchapter S corporation, and limited liability company on the issues of: (1) formation (what documents are needed to create each); (2) liability; and (3) taxation. What are retained earnings? How are they treated tax-wise? What types of business organization(s) can utilized the financial planning tool of retained earnings?

Answer 1

General Partnerships

A general partnership is the most common type of partnership. It refers to a relationship in which all partners contribute to the day-to-day management of the business. Each partner will have the authority to make business decisions and even legally bind the company in contracts.

The liabilities, contributions, and responsibilities of the partners are often equal unless stated otherwise. Typically, a partnership agreement will describe which partners have certain authorities and responsibilities.

Limited Partnerships

A limited partnership is a relationship where the limited partner may not be involved in the day-to-day management of the business. This partner may have just contributed funds to the business, and often the funds that they contribute are the extent of their liability. Limited partnerships will still have at least one general partner to man the day-to-day operations of the business.

The general partner may also be personally liable for the debts of the company, while the limited partner is not. A general partner’s liability is not limited to their investment. Their personal assets can come into play when it comes to paying off the company’s debts.

A common purpose of a limited partnership is for real estate. There may be several limited partners for the purpose of raising additional funds to purchase the real estate, as long as there is at least one general partner. The benefit of being a limited partner is so your liability is limited, while the downside is that a limited partner will not have the decision-making powers that a general partner would.

Retained Earnings (RE) are the portion of a business’s profits that are not distributed as dividends to shareholders but instead are reserved for reinvestment back into the business. Normally, these funds are used for working capital and fixed asset purchases (capital expenditures) or allotted for paying off debt obligations.

Retained earnings represent the net income earned by a corporation but not yet distributed, either in the form of compensation to employees or as dividends to shareholders. In essence, it is earnings that have been “retained” or “kept” by the company. This can present a tax problem, because a corporation is a taxed entity and retained earnings that remain with a corporation are not taxed unless certain conditions are met. Usually a company will eliminate retained earnings by paying management a year-end bonus or dividends to its shareholders.

Retained Earnings Tax

If a corporation keeps too much retained earnings, the excess may be subject to a special corporate income tax. As a general rule, corporations are allowed to keep $250,000 in retained earnings without any special tax. If retained earnings exceed this amount, the corporation must file a form 1120-F with IRS; this form reconciles the excess retained earnings. Sometimes a business might be justified in keeping excess retained earnings. For example, a company might be preparing to purchase a large real estate asset and will need as much excess capital as possible to complete the purchase. The tax rate for undistributed retained earnings is 39.6 percent.

When a company accumulates excess retained earnings, the retained earnings must be distributed either as a dividend or wages. Wages are generally preferable, because a dividend creates a double taxation issue. This is because dividends are not deductible by the corporation against profit, and the recipient of dividends must report the dividends received as income. On the other hand, a wage paid by the corporation will reduce taxable profit and minimize corporate income tax.