Avoiding Accumulated Earnings Tax
September 10, 2021
Corporate taxpayers that retain earnings in excess of the reasonable needs of their business rather than pay such earnings as dividends to shareholders are at risk for the accumulated earnings tax (AET), which is a form of penalty tax that is intended to make corporations distribute their taxable income to shareholders, rather than accumulate the income. Without the penalty tax, corporations would have an incentive to hold on to the income so that the shareholders do not have to pay tax when the income is distributed as dividends.
The AET is primarily an issue for closely held companies because closely-held companies are more likely to have a dividend policy influenced by a single shareholder or a small group of shareholders. However, all corporations other than personal holding companies, tax-exempt corporations, passive foreign investment companies, and S corporations are subject to accumulated earnings tax. The accumulated earnings tax rate is 20 percent of accumulated taxable income. The accumulated earnings tax is imposed in addition to the corporation’s regular income tax. Generally, a corporation’s accumulated taxable income is calculated as follows:
Corporation’s regular taxable income
– Certain federal taxes
– Excess charitable deductions
+ Dividends received deductions
+ Net operating losses
– Certain capital gains and losses
– Dividends paid to shareholders
– Accumulated earnings credit
The accumulated earnings credit is generally the amount of earnings and profits for the year that are retained for the reasonable needs of the business, minus the net capital gain deduction. Simply put, these adjustments are intended to better reflect how much cash the corporation has available to make dividend distributions and if accumulations equal business needs the corporation will prevail since the accumulated earnings credit reduces accumulated taxable income to zero.
The accumulated earnings tax is imposed only on those corporations formed or availed of for the purpose of avoiding income tax with respect to their shareholders by permitting earnings and profits to accumulate instead of being distributed. Thus, the intent of the shareholders in forming the corporation and the intent of the corporation in retaining earnings are crucial to the imposition of the tax. The Supreme Court has held that the purpose of avoiding the shareholder tax need not be the sole or even the dominant purpose for the accumulation. Even if the improper purpose is only one of the purposes of the corporation, the corporation is considered to be formed or availed of for the purpose of avoiding tax. Although the corporation can overcome the presumption by showing by the preponderance of the evidence that earnings and profits were not accumulated to avoid the tax, it is the corporation that must satisfy the burden of proof by offering evidence that demonstrates their claims are more likely to be true than not true.
Accumulation of income is allowed as long as there is a reasonable business need for the accumulation and a plan for its use. What the reasonable needs of a business varies depending upon the particular facts and circumstances. The IRS’ regulations provide guidance on what a valid purpose is for the accumulation of earnings, based on established case law. The following are examples of business needs that may constitute valid business purposes for which an accumulation might be justified:
· bona fide expansion of business or replacement of plant;
· acquisition of another business enterprise;
· retirement of bona fide business debt;
· working capital needs;
· providing investments in or loans to suppliers if called upon by business necessity; and
· providing for reasonably anticipated products liability losses.
The dramatic reduction in the corporate tax rate from 35% to 21% has caused greater interest in the AET. If the corporation has accumulated earnings or anticipate earning above the allotted amounts, proper steps of documentation are furthermore important to strengthen your case and void this tax.