What is the Accumulated Earnings Tax?

If a C corporation retains earnings (doesn't distribute them to shareholders) above a certain amount, the corporation may be assessed what is called an accumulated earnings tax.

Accumulated earnings in a C corporation and personal service corporation, above certain exemption limits, may incur a 20% accumulated earnings tax (15% prior to 2013).

Purpose of the Tax

The purpose of the accumulated earnings tax is to discourage the accumulation of earnings it the reason for such accumulation is to allow shareholders to avoid paying taxes on such earnings.

Exemption Amounts

C corporations may accumulate earnings up to $250,000 without incurring an accumulated earnings tax.

A personal service corporation (PSC) may accumulate earnings up to $150,000 without having to pay this tax.

Tax Rate and Interest

If a corporation accumulates earnings that exceed the exemption amounts an accumulated earnings tax of 15% of the excess earnings may be imposed by the IRS.

In addition, interest applies to the tax from the date the corporate return was due, without extensions.

A Silver Lining:

Even if the exemption amount is exceeded, regardless by how much, if the earnings are being accumulated for what the IRS considers to be the reasonable needs of the business, then the accumulated earnings tax won't be imposed.

The question is, what does the IRS consider reasonable needs of the business?

Here's what the IRS says the reasonable needs of a business are:

  • Specific, definite, and feasible plans for use of the earnings accumulation in the business.
  • The amount necessary to redeem the corporation's stock included in a deceased shareholder's gross estate, if the amount does not exceed the reasonably anticipated total estate and inheritance taxes and funeral and administration expenses incurred by the shareholder's estate.

Business expansion, constructing a new facility, and investing in newer and more productive equipment are reasonable business needs.

S corporations don't have a problem with accumulated earnings because earnings are taxed to S corporation shareholders even if they're not distributed to them.

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