If your business is fortunate enough to be profitable after you’ve paid your expenses and taxes, you should be able to squirrel away some cash. In C corporations, the profits you set aside are called retained earnings (and you need a business reason for accumulating more than a certain amount in order to avoid a tax penalty). In other types of businesses, the funds you don’t immediately pay out to owners or plow back into the business are simply called savings (and there’s no cap to your set asides).
Reasons for Savings
Retained earnings or savings can be used for a number of important things:
- Capital Acquisitions and Expansion
Instead of seeking a commercial loan to pay for the purchase of big ticket items such as new equipment and machinery, plants, or big marketing campaigns, you can be your own banker. Avoiding the need to take a loan will save you the interest you’d otherwise have to pay on the borrowing.
- Buying Out a Departing Owner
If the business has the cash and an owner wants out or dies, the money can be used to buy out the owner’s interest.
- Rainy Day
If your business hits a bump in the road, your savings can pay the rent and other expenses until cash flow returns to normal. Having an emergency fund can mean the difference between staying in business or going under.
Rule of thumb: If possible, build up a cash reserve that can carry you through tough times. The NYS Small Business Development Center suggests a one-year cash reserve, but an emergency fund of this size may be difficult to achieve. Some financial experts suggest four to six months as an adequate nest egg for emergencies.
What To Do with Savings
If you don’t have an immediate need to access funds for anticipated expenses, put them to work by earning interest for your business. Consider these banking products:
- Interest Checking Accounts
If you maintain a certain balance in your business bank account, you may earn interest. Parking cash here is useful if you expect to draw on the funds, but it won’t earn you much interest.
- Money Market Accounts
These interest-bearing accounts at banks offer rates that are higher than interest-checking accounts and allow for penalty-free access at your discretion. They’re FDIC-insured up to $250,000.
- Certificates of Deposit (CDs)
These instruments are purchased through a bank for a set term ranging from seven days to 10 years. Usually, the longer the term, the higher the interest rate. You can use a term that matches your expected use of the funds. For instance, if you’re planning in one year to buy a new machine to replace the one you now have, then a one-year CD would be suitable. Split the funds into various CDs with different maturities to match your different needs; don’t lock in all your savings for the long term because there are penalties on premature withdrawals.
Bank products are not your only choices. Also consider investments through:
- Credit Unions
Credit unions that you can join offer many bank-like savings products.
- Brokerage Firms and Mutual Fund Companies
Stocks, bonds, and mutual fund shares are also available to businesses, but may entail risk (something you’re already doing by being in your own business). One relatively safe option is a money market mutual fund. Like bank money market accounts, these pay interest and provide for liquidity. While they are not FDIC-insured, their rates may be higher than bank funds, so compare.
Should C Corporations Retain Earnings?
As a practical matter, many small C corporations don’t have any retained earnings; they try to “zero out” income (balance income with compensation to owners and other expenses) to avoid any corporate-level income tax. However, in some cases, pre-planning with an accountant may be wise so that the corporation takes advantage of low tax rates on income up to certain levels; it will then have retained earnings.
Bottom Line
Before stashing your cash, talk with your accountant or other financial advisor to make sure your cash needs are met, you’ve added what you could to your 401(k) or other qualified retirement plan for tax-advantaged savings, and your investment selections for your retained earnings or savings make sense for your business.
