What is the Accumulated Earnings Tax?

If a C corporation retains earnings (doesn't distribute them to shareholders) above a certain amount, an amount which the IRS concludes to be beyond the reasonable needs of the business, the corporation may be assessed tax penalty called the accumulated earnings tax ( IRC section 531) equal to 20 percent of accumulated taxable income.

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 if the reason for such accumulation is to allow shareholders to avoid paying taxes on such earnings by not paying them dividends. Keep in mind, this is not a self-assessed tax, it can be imposed via IRS review of a corporation.

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 20% (15% prior to 2013) 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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