When a corporation accumulates earnings without a reasonable business need and does not distribute out dividends to its shareholders, the corporation may be liable for the accumulated earnings tax in addition to its regular corporate income tax.

Are All Corporations Subject to the Accumulated Earnings Tax?

No. The following types of corporations are not subject to the accumulated earnings tax:

1. Personal holding companies;
2. Foreign personal holding companies;
3. Tax-exempt organizations;
4. Foreign passive investment companies; and
5. S corporations.

On What Does the Accumulated Earnings Tax Impose a Tax?

The accumulated earnings tax is basically a 15% tax on the corporation’s "accumulated taxable income" for the tax year.

What is "Accumulated Taxable Income"?

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

What is "Accumulated Earnings Credit"?

Accumulated earnings credit is the greater of the following two amounts:

  1. $250,000 (or $150,000 for personal service corporations) less the amount of accumulated earnings and profits at the end of last tax year; or
  2. The amount of current year earnings and profits that are retained for reasonable business needs in excess of dividends paid to the shareholders, less the net capital gains deducted in calculating accumulated taxable income.

"Earnings and profits" is not the same as a corporation’s taxable income, but it resembles more of the corporation’s "book" or accounting income.

"Accumulated earnings and profits" is basically a running total of the corporation’s earnings and profits over the years less the amount of dividends paid to shareholders during the current tax year (but no later than 2 months and 15 days after the close of the tax year).

How Can I Avoid Paying the Accumulated Earnings Tax?

There are several ways a corporation can avoid paying this additional tax:

  1. Pay dividends to shareholders during the tax year (or within 2 ½ months after the close of the tax year);
  2. Issue consent dividends to shareholders (Consent dividends are treated just like regular dividends to the recipient for income tax purposes, but they do not need to be actually paid out by the corporation);
  3. Retain earnings for reasonable business needs and document them in a "specific, definite, and feasible"plan; or
  4. Do not keep an accumulated earnings balance that exceeds $250,000 (or $150,000 for personal service corporations)

What Are Some Examples of Reasonable Business Needs?

Reasonable business needs include any of the following:

  1. Expansions of planned facilities and activities;
  2. Acquisitions of related businesses;
  3. Loans to help customers and suppliers of the corporation;
  4. Reserves to meet competition;
  5. Contingent liabilities that are realistically foreseeable.

Do I Need an Attorney to Help Me with My Tax Problems?

Tax laws are complex and ever-changing. Although there are various tax preparation software on the market that may help you with your tax problems, they cannot provide the same level of service that an experienced and knowledgeable tax attorney can. If you are unsure about your taxes or you need someone to represent you before the IRS, a business attorney can help you.