By nature, the corporate world is subject to two levels of tax: tax at the corporate level on income and tax at the shareholder level upon receipt of dividends. As a result, corporations could be tempted to withhold dividend distributions to save their shareholders from tax. The accumulated earnings tax (AET) was put in place to prevent corporations from doing just that. If the IRS finds that a corporation is accumulating income for the purpose of avoiding tax rather than supporting the business itself, a 20% penalty tax is levied on the accumulated taxable income.
What Are the Details on the Tax?
According to Internal Revenue Code (IRC) §535, accumulated taxable income is generally calculated as follows: taxable income, minus the sum of the dividends paid deduction and the accumulated earnings credit. This amount is further reduced or increased by a variety of adjustments laid out in IRC §535(b), including allowing for charitable contributions to be deducted without limitation and disallowing any net operating loss. Once again, the tax can be levied if the IRS identifies that a corporation is withholding dividends and accumulating earnings for reasons other than “reasonable needs of the business.”1 The concept of intent is interesting here, as the IRS must subjectively analyze why a corporation may be keeping funds rather than providing dividends to their shareholders. That being said, there is generally a $250,000 accumulated earnings credit ($150,000 in the case of certain service corporations) meaning that corporations can accumulate up to that amount of earnings without explanation or concern for the additional tax.
It is important to note that some corporations are exempt from this tax: personal holding companies, tax-exempt corporations, and passive foreign investment companies.2 Also, the AET is not a self-reported tax, but is rather a tax imposed by the IRS upon exam. Therefore, while it may not be top of mind for corporations, it is certainly something to be cognizant of when planning dividend distributions and availability of cash.
How Does the IRS Determine the Purpose for Accumulated Income?
As previously mentioned, the determination of having a reasonable business need versus having a tax avoidance purpose is largely subjective. Ultimately, “reasonable needs of the business” is defined by IRC §537(a) to include: “(1) the reasonable anticipated needs of the business, (2) the section 303 redemption needs of the business, and (3) the excess business holdings redemption needs of the business.” Further, the burden is on the taxpayer to prove that the purpose is not tax avoidance, but rather for a “specific, definite, and feasible”3 bona fide business purpose and plan.4 The funds ultimately should be used in a reasonable amount of time after the end of the year. Regulations support that the following business needs are reasonable: expansion of the business, acquisition of a business, retirement of debt, to provide the appropriate level of working capital for the business, loans to customers, and product liability loss.5 On the other hand, a corporation that is solely an investment company is automatically assumed to be subject to the AET unless the corporation can prove otherwise. 6
Courts have also weighed in on the concept of “reasonable needs of the business.” For example, to calculate what the courts deem reasonable in terms of working capital need, various methods have been used: sufficient working capital to cover one year of business operations,7 complying with standards of working capital balances set by others,8 and a formula used in the Bardahl Manufacturing Corp. tax court case. Often, the Bardahl formula is used to determine the amount that a corporation “reasonably could have anticipated as being needed to finance its normal operating costs for a single operating cycle.”9 FORVIS can work with you to estimate the formula calculation for your corporation.
Historically, certain shareholder characteristics have come into play regarding whether or not the IRS assesses the AET. The first is the wealth of the shareholders. Wealthy shareholders are likely taxed in a high tax bracket and would have less use for the funds received in a dividend.10 The second is the sophistication of the shareholders who also participate in the management of the business (“shareholder managers”). Shareholder managers with a taxation or financial planning background would likely be more motivated and knowledgeable about avoiding distributions for tax purposes.11 Both of these have been indicators to the IRS that the accumulation of earnings and profits is not for a business need.
Recently, we have seen the AET being raised as a potential issue during IRS exams. As a result, profitable corporations should consider estimating and documenting their planned business uses for retained earnings as well as proactively planning around dividend distributions. While there are some rules guiding this tax, there is much room for interpretation.
FORVIS can assist with evaluating and documenting your corporation’s retained earnings needs as well as helping you proactively plan around dividend distributions. Reach out to your professional at FORVIS or fill in our Contact Us form below for more information.
- 1 IRC § 533(a)
- 2IRC § 532(b)
- 3 Reg §1.537-1(b)(1)
- 4Reg §1.537-1(a)
- 5Reg §1.537-2(b)
- 6Reg § 1.533-1(a)(2)
- 7J. L. Goodman Furniture Co., 11 TC 530
- 8F. E. Watkins Motor Co., 31 TC 288
- 9Bardahl Manufacturing Corp., TC Memo 1965-200, 07/23/1965
- 10 Trico Products Corporation., 46 BTA 346
- 11 Golconda Mining Corp., 58 TC 139, 04/27/1972