What Is Retained Earnings? The Formula, a Four-Year Example, and Why It Is Not Your S Corp's AAA
Retained earnings is the total profit a corporation has kept since it started, minus everything paid out to its owners: beginning retained earnings + net income - distributions = ending retained earnings. As of October 2026, an S corporation reports it on Schedule L but tracks a separate tax account, the AAA, on Schedule M-2.
What is retained earnings? The short answer
Retained earnings is the total profit a corporation has kept in the business since it started, after subtracting everything it paid out to its owners. The formula is: beginning retained earnings + net income - distributions (or dividends) = ending retained earnings. It sits in the equity section of the balance sheet, and it is not cash.
As of October 2026, that one line carries more weight for small corporations than most owners expect. An S corporation reports retained earnings on its balance sheet (Schedule L of Form 1120-S), but the IRS tracks a different running total, the accumulated adjustments account (AAA), on Schedule M-2, and that is the one that decides how distributions are treated. This guide rolls one company's retained earnings forward over four years, puts it next to its AAA, and shows where the two stop agreeing.
The retained earnings formula: beginning retained earnings + net income - distributions = ending retained earnings
Every year, retained earnings moves for two reasons:
- Net income (or a net loss) from the income statement. Profit adds to it; a loss subtracts.
- Distributions or dividends paid to the owners. An S corporation calls them distributions; a C corporation pays dividends. Either way they come out of retained earnings, not out of expenses.
That is why the formula only needs three inputs. Start with last year's ending balance, add this year's net income (or subtract the loss), subtract what the owners took out. The result is this year's ending balance, and it becomes next year's beginning balance.
What does not move retained earnings: money the owner puts in (that is paid-in capital), loan payments (those change cash and the loan balance), and the owner's salary. The salary is already an expense on the income statement, so it lowered net income before the formula ever ran.
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One company's retained earnings, four years in a row
Take the hypothetical HVAC service company from our balance sheet page: an S corporation that ended this year with $97,000 of retained earnings on $480,000 of revenue. Here is how it got there, starting from its first year. The figures are illustrative.
| Year | Beginning retained earnings | + Net income (loss) | - Distributions | = Ending retained earnings |
|---|---|---|---|---|
| Year 1 | $0 | ($18,000) | $0 | ($18,000) |
| Year 2 | ($18,000) | $40,000 | $10,000 | $12,000 |
| Year 3 | $12,000 | $90,000 | $30,000 | $72,000 |
| Year 4 (this year) | $72,000 | $75,000 | $50,000 | $97,000 |
Three things to read off this table:
- Year 1 is an accumulated deficit. The first-year loss made retained earnings negative. On a balance sheet that shows as a negative number in equity, and it means the business has lost more, in total, than it has kept.
- Years 2 through 4 add up. Total net income over four years is $187,000. Total distributions are $90,000. The difference, $97,000, is this year's ending balance. Retained earnings is simply lifetime profit minus lifetime payouts.
- It is not the bank balance. The same company has $62,000 of cash at year end against $97,000 of retained earnings. The kept profit is spread across cash, $40,000 of unpaid customer invoices, parts and the depreciated vans, and some of those assets were also financed with loans.
Where retained earnings lives in your books
Retained earnings is an equity account, in the 3000s of a typical chart of accounts. Nobody posts to it day to day. Revenue and expense accounts collect the year's activity; when the year closes, they reset to zero and the difference, the year's net income, moves into retained earnings. Accounting software usually does this for you, which is why the retained earnings balance on a mid-year report looks like it has not changed since January: the current year's profit is shown separately as "net income" until the close.
Distributions are usually recorded in their own equity account during the year and closed into retained earnings at year end. Keep them separate from wages and from loans to the owner. A transfer to the owner with no label is the hardest thing to fix later, because it could be any of the three.
Retained earnings vs the AAA on an S corporation's return
This is where an S corporation owner's numbers stop matching. The return asks for both:
- Schedule L, line 24, "Retained earnings" is book retained earnings, from a balance sheet that the IRS instructions say "should agree with the corporation's books and records."
- Schedule M-2, column (a), the accumulated adjustments account is a tax account. The IRS describes it as an account that "generally reflects the accumulated undistributed net income of the corporation" for its S corporation years. It starts at zero on the first day of the first S corporation year, goes up by income on the tax return, goes down by deductible losses, expenses and nondeductible expenses, and goes down by distributions.
They diverge for a few predictable reasons, all from the 2025 Form 1120-S instructions (read October 5, 2026):
| Difference | Retained earnings (books) | AAA (tax) |
|---|---|---|
| Which income it uses | Net income per books | Income on the tax return. Schedule M-1 reconciles the two, starting from line 1, "Net income (loss) per books" |
| Starting point | Includes profit kept from any years the company was a C corporation | Zero on the first day of the first S corporation year. C corporation profit is tracked separately as accumulated earnings and profits |
| Distributions larger than the balance | Can push it negative | Distributions reduce it "but not below zero" |
| Losses | Reduce it, and can make it negative | Reduce it too; "The AAA may have a negative balance at year end" |
Here is the HVAC company's year 4 side by side. Assume, hypothetically, that its tax returns have taken depreciation on the vans faster than its books have, so its tax income has run lower than its book income: $6,000 lower this year, and $12,000 lower in total before this year.
| Year 4 | Retained earnings (Schedule L) | AAA (Schedule M-2) |
|---|---|---|
| Beginning of year | $72,000 | $60,000 |
| + Income for the year | $75,000 (books) | $69,000 (return) |
| - Distributions | $50,000 | $50,000 |
| End of year | $97,000 | $79,000 |
Neither number is wrong. They measure different things, and the $18,000 gap is the depreciation timing difference, explained year by year on Schedule M-1. What matters is that your preparer carries both forward correctly, because next year's beginning balances have to match this year's ending ones.
Why the AAA, not retained earnings, limits your distributions
Owners often look at retained earnings and assume that is how much they can take out. For tax purposes, the IRS's ordering rule for an S corporation starts somewhere else. Unless the corporation makes an election, distributions are applied in this order:
- The AAA, "but not below zero."
- Previously taxed income from before 1983, if the corporation has any.
- Accumulated earnings and profits left over from C corporation years. Those distributions are dividends, reported on Form 1099-DIV.
- The other adjustments account.
- Any remaining shareholders' equity accounts.
Run the hypothetical company through it. Before distributions, its AAA for year 4 is $60,000 + $69,000 = $129,000. If the owner had taken $140,000 instead of $50,000, the AAA would stop at zero and the extra $11,000 would come out of the next accounts on the list. Its book retained earnings would still be positive ($72,000 + $75,000 - $140,000 = $7,000), which is exactly why retained earnings is the wrong number to plan distributions from. How that extra $11,000 is taxed depends on the shareholder's own situation; that is a question for your CPA before the money moves, not after.
One more rule from the same instructions: "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation." An owner who works in the business needs a salary that runs through payroll. Distributions are what comes on top of it, out of profit the corporation has already earned.
Retained earnings by business type
| How the business files | Does it have retained earnings? | Where profit kept in the business shows up |
|---|---|---|
| Sole proprietor or single-member LLC (Schedule C) | No | Owner's equity (capital) on the books, reduced by owner's draws. Schedule C has no balance sheet. |
| Partnership or multi-member LLC (Form 1065) | No | Partners' capital accounts, analyzed on Schedule M-2, "Analysis of Partners' Capital Accounts" |
| S corporation (Form 1120-S) | Yes | Schedule L, line 24 on the books side; the AAA on Schedule M-2 on the tax side |
| C corporation (Form 1120) | Yes | Schedule L, where the 1120-S instructions note that appropriated and unappropriated retained earnings go on separate lines; reconciled on Schedule M-2 |
The $250,000 shortcut applies to corporations of both kinds. A C corporation with total receipts and year-end total assets both under $250,000 does not have to complete Schedules L, M-1 and M-2 if it checks "Yes" on Schedule K, question 13. An S corporation's version is Schedule B, question 11, which drops Schedules L and M-1. The balance sheet guide linked above runs the $480,000-revenue company through that test; it fails it, so its retained earnings goes on the return.
What a negative retained earnings balance tells you
A negative balance, called an accumulated deficit, has one of two causes, and they mean very different things:
- Early losses. Like the company's year 1 above. Normal for a new business; it should shrink as profitable years add to it.
- Distributions larger than profit. The owners took out more than the business has earned over its life. That is money that came from somewhere else: loans, owner contributions, or cash the business needed for operations. Lenders reading your balance sheet notice this one.
If yours is negative and you are not sure which, line the four-year table above up against your own returns. Ten minutes with last year's Schedule L and this year's net income usually answers it.
Common retained earnings mistakes in small business books
- Owner pay booked as distributions, or distributions booked as wages. One overstates profit, the other understates it, and both leave retained earnings wrong.
- Opening balances that do not match last year's return. Schedule L has a beginning-of-year column, so the opening retained earnings has to equal last year's ending figure.
- Prior-year changes made after the return was filed. Editing a closed year in the software silently changes this year's opening retained earnings. Lock closed periods.
- Treating retained earnings as available cash. It is a running total of kept profit, not a balance you can spend.
Most of these are caught by a monthly close and a year-end tie-out to the return, the line between the two jobs described in bookkeeping vs accounting.
Watch the equity section every month
Retained earnings is the one line that ties every year's books together, so it is where errors from past years surface. SuperDupr's AI dashboards pull the balance sheet from your accounting software into one view each month, next to net income and distributions to date, and flag an opening balance that changed after a year was closed, so the gap gets found in the month it happens rather than at tax time.
The bottom line
Retained earnings is lifetime profit minus lifetime payouts: beginning retained earnings + net income - distributions = ending retained earnings. It lives in equity, it is not cash, and it can go negative. If you run an S corporation, it is also not the number that limits tax-free distributions. That is the AAA on Schedule M-2, which starts from your tax income, cannot be pushed below zero by distributions, and is worth asking your preparer for every year.
Sources (read October 5, 2026): IRS, Instructions for Form 1120-S (2025): Schedule L (line 24 retained earnings, "should agree with the corporation's books and records"), Schedule M-1, Schedule M-2 columns (a) through (d) and worksheet, Distributions general rule, and the Line 7 caution on reasonable compensation (irs.gov/instructions/i1120s); IRS, Instructions for Form 1120 (2025), Schedule L and the $250,000 exemption under Schedule K, question 13 (irs.gov/instructions/i1120); IRS, Instructions for Form 1065 (2025), Schedule M-2, Analysis of Partners' Capital Accounts (irs.gov/instructions/i1065). The HVAC company, its four-year history and its AAA figures are a hypothetical with illustrative amounts.
Frequently Asked Questions
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It is the profit a corporation has kept in the business over its whole life, after subtracting what it paid out to its owners as distributions or dividends. It is a running total in the equity section of the balance sheet, not an amount of cash.
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Beginning retained earnings + net income (or minus a net loss) - distributions or dividends = ending retained earnings. For example, $72,000 at the start of the year, plus $75,000 of net income, minus $50,000 of distributions, ends the year at $97,000.
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No. It is part of equity, the owners' side of the balance sheet. The profit it represents is spread across assets like cash, receivables and equipment, so a company can have $97,000 of retained earnings and only $62,000 in the bank.
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Yes. A negative balance is called an accumulated deficit. It comes either from losses, which is common in a company's first years, or from owners taking out more in distributions than the business has earned over its life.
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Retained earnings is a book figure on Schedule L of Form 1120-S. The accumulated adjustments account (AAA) is a tax figure on Schedule M-2: it starts at zero in the first S corporation year, uses income from the tax return, and distributions cannot reduce it below zero. Under the IRS ordering rule, distributions come out of the AAA first, so it, not retained earnings, is the number to plan distributions from.
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Not unless the LLC is taxed as a corporation. A sole proprietor or single-member LLC tracks owner's equity, reduced by draws. A partnership or multi-member LLC tracks partners' capital accounts, which Form 1065 analyzes on Schedule M-2. An LLC that elected S corporation status has retained earnings like any other S corporation.