Accumulated Earnings Tax: The Brown Recluse of C-Corps

TLDR: Beware of the sneaky avoidable tax.

 If you're like me, you're probably loving the 21 percent corporate tax rate and now keeping more money inside the corporation. I mean, you can't beat it.

If so, beware of the accumulated earnings tax. You can easily overlook it. You likely don’t have the proper documentation to avoid it. And it’s expensive. Like, a lot.

The accumulated earnings tax is a 20 percent corporate-level penalty tax assessed by the IRS, as opposed to a tax paid voluntarily when you file your company’s corporate tax return.

To trigger the tax, you need to suffer an IRS audit that notes your failure to pay dividends when

• the corporation’s accumulated earnings exceed $250,000, or $150,000 for a personal service corporation, and

• the corporation cannot demonstrate an economic need for the “excess” accumulation of earnings.

Here’s the question: Why do you need more than $250,000 ($150,000 if you are a personal service corporation) in accumulated earnings?

If you can answer this question to the satisfaction of the IRS, you have no problem.

But don’t wait for the audit and the question. Be proactive. Get your reasons and dollar amounts into the corporate minutes. Here are some prompts to get you started on why you need to keep the earnings in the corporation:

• You need the money to pay a deceased shareholder’s death taxes, funeral, and administrative expenses under IRC Section 303. After all, shareholders do die.

• You need the money to shut down operations, sell the business, and otherwise deal with corporate needs caused by the owner’s (shareholder’s) death.

Let’s move away from death. The IRS in Reg. Section 1.537-2 gives you a nice list of reasons for accumulating C corporation earnings, as follows:

• Provide for bona fide expansion of business or replacement of plant

• Acquire a business

• Retire indebtedness of the corporation

• Provide for investments in or loans to suppliers or customers if necessary to maintain the business of the corporation

• Provide for reasonably anticipated product liability losses

From this same regulation, the IRS lists the following as likely unreasonable reasons for accumulating the earnings:

• Making loans to the shareholders

• Making loans to other corporations and business entities owned by the shareholders

• Investing in properties unrelated to the corporation’s activities

• Investing in securities unrelated to the corporation’s activities

• Citing needs for unrealistic contingencies and hazards

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