An accumulated earnings tax is a tax imposed by the federal government on corporations with retained earnings deemed to be unreasonable or unnecessary. The point of this tax is to encourage companies to issue dividends to their shareholders rather than sit on the earnings (which, ironically, often leads to the shareholders paying taxes on the dividend income to carry out the corporate double-taxation scheme imposed by law). However, the IRS will allow certain exemptions to the accumulated earnings tax rule to permit companies to hold more funds than normal.
STATUTORY BASICS OF THE ACCUMULATED EARNINGS TAX
- ACCUMULATED TAXABLE INCOME: Pursuant to 26 U.S.C. §535(a), “Accumulated taxable income” means the taxable income of the corporation MINUS ALL of the following:
- Allowed Adjustments: Deductions are allowed for federal income taxes paid, excess profit taxes paid to foreign countries, qualifying charitable deductions, and taxes attributable to net capital gains. However, special deductions for corporations such as the deduction for dividends received and the net operating loss are not allowed for this calculation. 26 U.S.C. §535(b).
- Dividends Paid In That Tax Year To Shareholders.
- Accumulated Earnings Credit: “[I]n the case of a corporation other than a mere holding or investment company the accumulated earnings credit is an amount equal to such part of the earnings and profits for the taxable year as are retained for the reasonable needs of the business.” 26 U.S.C. §535(c)(1). The minimum accumulated earnings credit allowable is $250,000.00. 26 U.S.C. §535(c)(2)(A). “In the case of a corporation the principal function of which is the performance of services in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting” the minimum accumulated earnings credit allowable is $150,000.00. 26 U.S.C. §535(c)(2)(B).
- AMOUNT: The accumulated earnings tax is equal to 20% of the “accumulated taxable income” and is imposed in addition to other taxes required under the Internal Revenue Code. 26 U.S.C. §531.
- REASONABLE NEEDS OF THE BUSINESS: It is presumed that a corporation can retain up to $250,000.00 (or $150,000.00 for certain service corporations) for the reasonable needs of the business without question. Otherwise, for the purposes of justifying retention of an amount beyond those minimums, the corporation has to demonstrate that it has retained only enough earnings to satisfy “the reasonably anticipated needs of the business.” 26 U.S.C. §537(a).
- CORPORATIONS SUBJECT TO TAX: The accumulated earnings tax applies to every corporation “formed or availed of for the purpose of avoiding the income tax with respect to its shareholders or the shareholders of any other corporation, by permitting earnings and profits to accumulate instead of being divided or distributed.” 26 U.S.C. §532(a). It does not matter how many shareholders the corporation has (even if there is only one). 26 U.S.C. §532(c). However, the accumulated earnings tax does not apply to the following corporations:
- Personal Holding Companies (PHC) – Defined as C-Corporations where 50% or more of the outstanding stock is owned directly or indirectly by 5 or less individuals AND at least 60% of its adjusted ordinary gross income is from passive sources (e.g. rental properties). 26 U.S.C. §532(b)(1).
- Corporation Exempt From Tax – Includes 501(c)(3) non-profit corporations, churches, charities, foundations, etc. 26 U.S.C. §532(b)(2).
- Passive Foreign Investment Company – Any foreign corporation where 75% or more of the gross income is passive income OR at least 50% of the assets held by the corporation are held for the production of passive income. 26 U.S.C. §532(b)(3).
- UNREASONABLE ACCUMULATION IS EVIDENCE OF PURPOSE TO AVOID TAX: According to the Internal Revenue Code, “the fact that the earnings and profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation by the preponderance of the evidence shall prove to the contrary.” 26 U.S.C. §533(a). “The fact that any corporation is a mere holding or investment company shall be prima facie evidence of the purpose to avoid the income tax with respect to shareholders.” 26 U.S.C. §533(b).
WHAT ARE THE “REASONABLE NEEDS OF THE BUSINESS”?
The IRS and corporations can and do find themselves battling in the U.S. Tax Court over the imposition of the accumulated earnings tax. The primary defense usually levied by the corporation is that the accumulated earnings beyond $250,000.00 were essential to the “reasonable needs of the business”. If the accumulated taxable income satisfies the reasonable needs test, then the accumulated earnings tax will be defeated.
Per the Internal Revenue Manual which provides guidance to IRS revenue agents in investigating and examining tax returns, the following factors are to be considered in determining reasonable needs under IRM 184.108.40.206.4.2:
- “(1) The term “reasonable needs of the business” includes the reasonably anticipated future needs of the business.”
- “(2) The following items, while not exclusive, may indicate that the earnings and profits are being accumulated for the reasonable needs of the business and should be used as guides:”
- “a. Bona fide expansion of business or replacement of plant”
- “b. Acquisition of a business enterprise through purchasing stock or assets”
- “c. Retirement of bona fide indebtedness created in connection with the trade or business, such as the establishment of a sinking fund for the purpose of retiring bonds issued by the corporation in accordance with obligations incurred on issue”
- “d. Necessary working capital for the business”
- “e. Investments or loans to suppliers or customers”
- “(3) Apart from the grounds specifically mentioned above, accumulations may be justified by a range of business needs. Among these are the following:”
- “a. Redemption of stock held by minority stockholders”
- “b. Need to meet competition”
- “c. Reserves for various business risks and contingencies such as self-insurance against casualties, potential liability from litigation, and unsettled business conditions”
- “d. Need to finance pension or profit sharing plans for the employer”
- “e. Possible loss of principal customer”
- “f. The IRC 303 redemption needs of the business. Examiners should thoroughly investigate the facts and circumstances in the case with a view toward determining whether the redemption was for a corporate purpose or was primarily for the benefit of the stockholders in a redemption of the stock of a minority or a majority stockholder”
- “g. Need to redeem excess business holdings of shareholders under IRC 4943 Taxes on excess business holdings”
In addition, “[a]ccumulations have been justified as a result of various forms of contingencies including the following” under IRM 220.127.116.11.4.3”
- “a. An actual or potential lawsuit”
- “b. A possible liability arising out of some contractual obligation”
- “c. A possible business reversal resulting from the loss of a customer”
- “d. Accumulations to guard against competition has been justified in some cases”
- “e. An accumulation to provide funds to finance a self-insurance plan. This includes key men/women, as well as the more common types of risk insurance”
- “f. Accumulations to provide a retirement plan for employees”
For financing corporate operations, the IRS cannot require the corporation “to resort to the borrowing of funds under any circumstances.” IRM 18.104.22.168.4.4. “Therefore, the current operations of the business or planned expansion may be financed fully by retained earnings.” Id.
In making these determinations, the IRS will consider whether the corporation had bona fide plans to expand the business with information such as minutes from shareholder meetings, blueprints, financial statements and proposed budgets. In addition, the IRS “may consider subsequent events to determine the taxpayer actually intended to carry out or has actually carried out the plans for which the earnings and profits were accumulated.” IRM 22.214.171.124.4.5(2). “If the earnings are not used to accomplish the purpose for which they were to be used, this may indicate that the earnings were not to be used for the indicated purpose in the first place and will make any future accumulations more difficult to justify.” IRM 126.96.36.199.4.5(4). Playing games with the IRS in past years will make it harder to justify accumulated earnings in future years, even for legitimate purposes, which can affect the corporation’s growth and sustainability.
THE BOTTOM LINE
Corporations big and small that stockpile profits may be subject to the accumulated earnings tax. If the Internal Revenue Service comes around with the intention of imposing this 20% tax, you can benefit from investing in the services of skilled legal counsel to help defend you against this assessment.
If you have any questions about the accumulated earnings tax or need legal representation, then do not hesitate to contact the experienced attorneys at Kershaw, Vititoe & Jedinak PLC for assistance today.