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What Triggers the Accumulated Earnings Tax?

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One disadvantage of C corporation structure is the possibility of double taxation. A C corporation’s income is subject to two levels of income tax: once at the corporate level and a second time at the shareholder level when income is distributed in the form of dividends.

To avoid — or at least defer — double taxation, many corporations retain earnings rather than distribute them to shareholders. This strategy can backfire, however, by triggering the accumulated earnings tax (AET).

What is the Accumulated Earnings Tax?

The AET is a 20% penalty on undistributed taxable income. The IRS may impose the tax if it finds that a corporation has accumulated an unreasonable amount of earnings with the intent of avoiding income tax.

The IRS may conclude that such intent exists if, for example, the corporation: 1) retains earnings beyond its reasonably anticipated future needs, 2) places undistributed earnings in investments that aren’t business related, or 3) makes personal loans to shareholders or otherwise spends money for their benefit.

An accumulated earnings tax credit shields the first $250,000 in accumulated earnings ($150,000 for some personal service corporations) from the AET. After your corporation exceeds that threshold, though, you should take steps to avoid accumulated earnings tax liability. Options include:

  • Documenting the business reasons that justify a higher level of accumulated earnings (for example, with detailed plans and budgets for expansion of the business), or
  • Documenting how the corporation’s investments are related to its business (for example, by showing how these investments provide a hedge against inflation, fund employee benefit plans or generate additional working capital).

Alternatively, you could simply pay sufficient dividends to shareholders to reduce your accumulated earnings below the threshold.

What about the Personal Holding Company tax?

It’s important to distinguish the accumulated earnings tax from the personal holding company (PHC) tax. Like the AET, the PHC tax is a 20% penalty tax on a PHC’s undistributed income.

A corporation is a PHC if: 1) at any time during the last half of the tax year, more than 50% of the value of its outstanding stock was held, directly or indirectly, by or for five or fewer individuals, and 2) at least 60% of its adjusted ordinary gross income is attributable to certain types of passive income, such as dividends, interest, rents, certain royalties or income from personal service contracts.

The PHC tax doesn’t apply to tax-exempt entities, banks, life insurance companies and some other types of corporations. Unlike the AET, the PHC tax applies to corporations that meet the tests mentioned above regardless of any intent to avoid income tax.

Best strategies

Our team can help you evaluate how the accumulated earnings tax or the PHC tax may affect your business. The next step is to determine the best tax strategies for your situation.