802 / What is the accumulated earnings tax?

Editor’s Note: The 2017 Tax Act limited the members of a controlled group of corporations (the members of which are determined as of December 31 of the relevant year) to a single $250,000 amount in order to compute the accumulated earnings credit ($150,000 if any member of the group is a service organization in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting).¹ This amount must be divided equally among the members of the controlled group unless future regulations provide that unequal allocations are permissible.²

A corporation is subject to a penalty tax, in addition to the otherwise applicable corporate income tax, if, for the purpose of preventing the imposition of income tax upon its shareholders, it accumulates earnings instead of distributing them.³ The tax is 20 percent of the corporation’s accumulated taxable income (15 percent for tax years beginning prior to 2013).⁴ Accumulated taxable income is taxable income for the year (after certain adjustments) less the federal income tax, dividends paid to stockholders (during the taxable year or within 2½ months after the close of the taxable year), and the “accumulated earnings credit.”⁵

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Planning Point: IRS officials have noted that additional guidance may be needed on the application of the accumulated earnings tax in the wake of tax reform. The 2017 tax reform legislation lowered the corporate tax rate from 35 percent to 21 percent, potentially providing motivation for some companies to convert to C corporation status rather than attempt to interpret the complicated pass-through provisions that apply post-reform. However, the legislation did not modify the accumulated earnings tax, which applies a 20 percent penalty tax to undistributed corporate earnings and profits in excess of the reasonable business needs of the company. This “reasonableness” standard can be difficult to interpret and could require additional guidance in the coming years, as more businesses may attempt to take advantage of lower corporate rates by simply distributing fewer dividends to business owners.

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The tax can be imposed only upon amounts accumulated beyond those required to meet the reasonable needs of the business since an accumulated earnings credit, generally equal to this amount, is allowed. A corporation must demonstrate a specific, definite and feasible plan for the use of the accumulated funds in order to avoid the tax.⁶ The use of accumulated funds for the personal use of a shareholder and his family is evidence that the accumulation was to prevent the imposition of income tax upon its shareholders.⁷ In deciding whether a family owned bank was subject to the accumulated earnings tax, the IRS took into account the regulatory scheme the bank was operating under to determine its reasonable needs.⁸ Most corporations are allowed a minimum accumulated earnings credit equal to the amount by which $250,000 ($150,000 in the case of service corporations in health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting) exceeds the accumulated earnings and profits of the corporation at the close of the preceding taxable year.⁹ Consequently, an aggregate of $250,000 ($150,000 in the case of the above listed service corporations) may be accumulated for any purpose without danger of incurring the penalty tax.

Tax-exempt income is not included in the accumulated taxable income of the corporation but will be included in earnings and profits in determining whether there has been an accumulation beyond the reasonable needs of the business.¹⁰ However, a distribution in redemption of stock to pay death taxes which is treated as a dividend does not qualify for the “dividends paid” deduction in computing accumulated taxable income (see Q 300, Q 303).¹¹

The accumulated earnings tax applies to all C corporations, without regard to the number of shareholders in taxable years beginning after July 18, 1984.¹²

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1. Under IRC § 535(c).