Legal Question in Business Law in California

If you are a partnership, then reserving money would indeed result in there being more income and profit to each of the partners.

A reservation of funds is NOT an expense of the entity and will not result in a tax deduction or other type of expense to offset income and profit. Only when the reserved money is spent on tax deducible expenses will the profit be reduced .

The same effect would be true if you are a shareholder in a corporation that is taxed as an "S" corp.

If you are a shareholder in a corporation, the corporation will pay tax on the profit of the business, not the shareholders.

Is the business really a partnership? Then the set-aside money is taxable income. The only business format where set-aside (retained) income is treated differently is a standard ("S") corporation, where the corporate income tax would be paid on the set-aside funds, but not the individual shareholders' tax.

I just write to correct Mr. Whipple on his misuse of the term "S" corporation. An S Corporation is not a "standard" corporation as he states. An "S" Corporation is one that in its Articles of Incorporation or Bylaws elects to be taxed under Subchapter S of the Internal Revenue Code. Subchapter S permits a business to operate in all respects as a corporation, but to be taxed as if it were a sole proprietorship or general partnership, if certain conditions are met. This avoids the company's profits being taxed, and then distributions to the owners being taxed again as dividends. A standard corporation is sometimes called a "C" Corporation to distinguish from an S Corp.

I should also mention that regardless of your business form, that reserve is going to be taxed. The rate and deductions may change depending on whether it is taxed at the business or owner level. If you are a partnership, there really is no way to avoid it being included in your personal taxable income as reported on the K-1 that the partnership will have to issue to you. What many partnerships do in the situation where a reserve is going to hit the owners with taxes for cash they never got, is to do a special distribution to pay all or part of each partner's tax out of the reserve (as if the business had been taxed on it like a corporation). Since you're already being taxed on the whole reserve, that distribution should have no tax impact.