Accumulated Earnings Tax Trap §531
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A corporation can accumulate its benefits for use in possible growing or other bonafide business reasons. However, if a company allows money to accumulate over the regular necessity of the business, it may be subject to an accumulated gains tax. If the accumulated earnings tax applies, interest will be charged on the underpayments of the tax from the day the corporate return was originally due, without extensions. This tax applies without regard to the number of shareholders in the corporation (§532(c); §531; §6601(b)(4)).
Another look at C corp. vs. S corp. in light of tax reform
Imposition of Penalty Tax
The total earnings tax is imposed on every taxpayer formed or availed for the purpose of avoiding income tax on its stock owners, by permitting earnings and profits to accumulate. For a corporation to avoid liability for accumulated earnings tax, if it collects earnings and profits beyond its reasonable business needs, it must show that tax avoidance by its shareholders is not one of the purposes of accumulation. The simple existence of a tax avoidance purpose is sufficient for imposing the accumulated earnings tax.
Note Certain transactions, such as loans to shareholders, investments in assets having no reasonable connection to the corporation’s business, and the corporation’s dividend history may indicate a prohibited purpose (Reg.§1.533-1(a)(2)).
Although publicly owned corporations are intended to be covered by this section, the IRS will undoubtedly have trouble finding the prescribed purpose in cases where the corporation’s stock is widely held. Closely held corporations are the primary targets in the imposition of this tax. Personal holding companies (§532(b)(1)) and S corporations (§1363(a)) are exempted from this tax.
The accumulated earnings tax is 20% (in 2017) of accumulated taxable income (§531). The corporation doesn’t report the tax. Instead, IRS assesses the tax if it believes any is due (Reg. §1.531-1). This tax is, also, lar corporate income tax.
Note: Tax-exempt income cannot directly be subject to the tax, however, such
income is taken into consideration in determining the reasonableness of accumulated earnings and profits (R.R. 70-497).
Under §535(a), the accumulated taxable income for the year to which the penalty tax applies is:
(a) The corporate taxable income for the year with the deductions and additions listed in §535(b), less
(b) The sum of:
(i) The accumulated earnings credit, and
(ii) The dividends paid deduction.
Accumulated Earnings Credit
To permit small corporations to accumulate a minimum amount of earnings and profits, an accumulated earnings credit (§535(c)) is available. Most corporations may accumulate earnings and profits of at least $250,000 without having to prove a business purpose. This amount is known as the minimum accumulated earnings credit. However, personal service corporations whose principal function is performing services in the fields of health, science, law, engineering, architecture, accounting, actuarial performing arts, or consulting are limited to $150,000. Quote from Government Publishing Office
Application of Credit to Controlled Groups
Where a controlled group of corporations exists, only one credit is available for the entire group and, if any one of the corporations is a personal service corporation, the entire group becomes limited to the $150,000 credit. The accumulated earnings tax is imposed on an annual basis. Therefore, only the improper accumulations for the year at issue, or for all open years are subject to the tax.
The defense against the IRS’ attempt to impose the accumulated earnings tax is to assert that the funds are being accumulated for a reasonable business purpose. The determining factor in whether or not a corporation is subjected to the accumulated earnings tax is whether or not profits are accumulated beyond the reasonable needs (or the reasonably anticipated needs) of the corporation. The corporation, therefore, must be prepared to show a business reason for the accumulation.
Read the below quote from Legal Information Institute
An accumulation of the earnings and profits (including the undistributed earnings and profits of prior years) is in excess of the reasonable needs of the business if it exceeds the amount that a prudent businessman would consider appropriate for the present business purposes and for the reasonable anticipated future needs of the business. The need to retain earnings and profits must be directly connected with the needs of the corporation itself and must be for bonafide business purposes (Reg. §1.537-1(a)).
Accumulations for future needs of a business are justifiable if the needs are reasonably anticipated (§537). An accumulation cannot be justified where the future needs of the business are uncertain or vague, where plans for the future use of accumulation are not specific, or the plan is postponed indefinitely (Reg.§1.537 1(b)(1)).
Working capital is generally considered to be one reasonable business need. However, the IRS’ view of what constitutes reasonable working capital needs for personal service corporations is explained somewhat by the Bardahl case (Bardahl Mfg. Co. v. U.S., 452 F.2d 604 (9th Cir. 1971)). Bardahl involved a non-service type corporation with inventory. The court created a formula based on the corporation’s operating cycle. This cycle is composed of an inventory turnover cycle and an accounts receivable turnover cycle. The cycle is then multiplied by the cost of goods sold and operating expenses, less depreciation and income taxes for the year. The result is the allowable working capital accumulation of the corporation at year end.
About Publication 531, Reporting Tip Income
Since service type corporations do not have an inventory, the IRS claims that their operating cycles are composed only of accounts receivable turnover cycles. Based on the Bardahl formula, the average professional corporation would only be allowed a one or two-month accumulation of
working capital. Fortunately, the courts have been more liberal than the IRS and have not rigidly applied the Bardahl formula.
Minority Stock Redemption
The accumulation of earnings and profits to fund the redemption of a minority stock interest has been held to serve a reasonable business purpose (Gazette Publ. Co. v. Self, 103 F. Supp. 799 (E.D. Ark. 1952)). Accumulations to redeem as much as 50% even appear to be safe (Mountain State Steel Foundries, Inc., v. Comm., 284 F.2d 737 (4th Cir. 1960); See also Hedburg-Freidheim Contracting Company, 251 F.2d 839 (8th Cir. 1958); and, Cadillac Textiles, Inc., TCM 1975-46 (the accumulation to redeem stock of two deadlock stockholders was not shown to be for a valid business purpose.)).
Majority Stock Redemption
The accumulation of earnings and profits to redeem a majority stock interest is another question entirely. In the Pelton Steel Casting Co. v. Comm., 251 F.2d 278 (7th Cir. 1958), the court held that the redemption of an 80% stock interest served only a shareholder purpose. This case probably does not, however, constitute a blanket condemnation of majority redemptions.
The key to establishing a viable business need to accumulate earnings to effect a redemption would appear to be the preservation of stockholder harmony without which a closely held corporation is likely to fail. The requirement of some state laws that a corporation redeem the stock of deceased shareholders would seem to establish the business purpose for the redemption, and in these cases, a corporate resolution setting forth these requirements and corporate purposes should be adopted. (reference 2-35)