Monitoring business equity is as important as knowing the amount of money in a company’s bank account. Adverse consequences arise if equity becomes negative.
Equity is all of the owner’s investment in the enterprise. Retained earnings are the component of equity comprising all profits that remain in the business. A new business has no retained earnings. Profit at the end of year one is retained earnings to start the second year. Subsequent accumulation of profits further adds to retained earnings.
Withdrawals of profit reduce equity. Business structure determines how an owner withdraws company profits for personal use. Proprietors withdraw money at will. Partners have the same privilege in proportion to their ownership percentages. S corporation shareholders receive distributions, and C corporation shareholders obtain dividends.
Contrary to popular perception, business owners can possibly withdraw more than accumulated profits. This creates negative retained earnings. When that happens, the business has more debt than assets. Selling or liquidating the operation will likely require owners to input capital for repaying liabilities.
The worst consequences of negative retained earnings occur with S corporations. Distributions to S corporation shareholders that create negative equity are taxed as capital gains – unless the shareholder is the source of loans to the business. In addition, a shareholder is not allowed a tax deduction for the loss of an S corporation when he or she has no equity or loan investment in the company.