Corporate Accumulation Penalty Taxes
Shareholders of closely held corporations who have no immediate need for cash can allow their corporation to retain its earnings so that it is not taxed as dividends. The value of the stock increases as retained earnings increases. Dividends can be taken out at a later time, thereby reducing the net present value of the tax, or the shareholders can sell the company for a higher price. Another reason for corporations to retain its earnings is so that it can invest in its business. However, earnings cannot be accumulated simply to avoid tax; otherwise, a penalty tax may apply, either as an accumulated earnings tax or as a personal holding company (PHC) tax that applies to personal holding companies.
These penalties apply to corporations, but they may also apply to a controlled corporate group, which is a group of corporations that have either a parent-subsidiary or brother-sister relationship. A parent-subsidiary control group exists if the parent corporation owns at least 80% of the voting power or value of the stock of at least 1 corporation in the group and at least 80% of the voting power of the other corporations is owned by corporations in the same group. A brother-sister control group is one in which more than 50% of the voting power or total value of all stock is owned by 5 or fewer individuals, estates, or trusts.
Accumulation penalties can be avoided if enough dividends are paid out during the year or within 2.5 months after the taxable year (IRC §563).
Accumulated Earnings Tax
If a corporation pursues an earnings accumulation strategy, where the accumulation is to avoid the tax on dividends rather than having a business purpose, then IRC §532 provides an accumulated earnings tax that can be assessed on accumulated earnings that have no clear business purpose. Publicly held corporations with many shareholders are also subject to the tax. However, the accumulated earnings tax does not apply to personal holding companies, tax-exempt organizations, or passive foreign investment companies.
The accumulated earnings tax is a penalty tax; thus, it is only paid when the IRS assesses the tax because, during an audit, it concluded that insufficient dividends were paid out compared to the amount of income accumulated. Interest is also assessed on any underpayment that is calculated starting on the due date of the corporation's tax return without extensions. Whether a corporation is required to pay the accumulated earnings tax is determined at the end of the tax year by comparing the needs of the business to its total liquid assets.
IRC §537 provides that corporations must have specific and definite plans that are also feasible to justify the accumulation of earnings for the future. Plans that are documented and approved by the Board of Directors are more likely to be accepted by the IRS.
One defense against the accumulated earnings tax is showing that the money has been invested in the business, which will be reflected in its balance sheet. Reasonable business needs include:
- acquisition of another business;
- business expansion or plant replacement;
- working capital;
- debt retirement;
- self-insurance for product liability risks; and
- loans to suppliers or customers pertinent to the corporation's business.
Uses of retained earnings that are not considered legitimate business uses include:
- any types of loans that benefit the shareholders, including loans to friends and relatives who, otherwise, have no other connection to the business, or to a controlled corporation;
- investments unrelated to the business; and
- self-insurance accumulations against unrealistic hazards.
Calculating the Accumulated Earnings Tax
Since the accumulated earnings tax is 20% of the accumulated earnings tax base, it is 1st necessary to determine that amount. Tax-exempt interest income is not part of the accumulated earnings tax base, but it is considered in determining whether the corporation has retained excess earnings. Although dividends are not deductible from ordinary taxable income, there is a dividends-paid deduction when determining whether the accumulated earnings tax or the personal holding company tax applies. The accumulated earnings tax base is equal to the accumulated taxable income:
Accumulated Taxable Income = After-Tax Income – Dividends Paid – Accumulated Earnings Credit
The accumulated earnings credit is equal to the current earnings that were retained specifically to pay for business needs. (Although the tax code refers to it as an accumulated earnings credit, it is actually a deduction.) However, even if the corporation lacks a business need, tax law accords it a $250,000 minimum credit ($150,000 for personal service corporations) minus accumulated earnings and profits (E&P) as of the start of the year, thus allowing a de minimis retention of earnings so that new corporations can finance their start, even if the earnings do not have an immediate business need. However, only one $250,000 accumulated earnings credit applies to corporations that are part of a control group, in which case the credit is divided equally among the corporations. Note also that when accumulated E&P reaches $250,000, then the accumulated earnings credit is zero.
Accumulated Earnings Tax = Accumulated Taxable Income × 20%
|Accumulated E&P on January 1||$225,000|
|Reported Taxable Income||$100,000|
|Corporate Federal Income Tax Paid||$22,250|
|Dividend Deduction||0||No dividend was paid.|
|Accumulated Earnings Credit||$25,000||= $250,000 – Accumulated E&P at Beginning of Year|
|Accumulated Taxable Income||$52,750||= Reported Taxable Income – Income Tax Paid – Dividend Deduction – Accumulated Earnings Credit|
|Accumulated Earnings Tax||$10,550||= Accumulated Taxable Income × 20%|
Personal Holding Company Tax
In times past, the tax rate of individuals was considerably higher than it was on corporations. Hence, wealthy individuals formed a holding company that would specifically hold investments so that the investment income would be taxed at a lower rate. Nowadays, however, the top marginal corporate tax rate of 38% isn't much lower than the top marginal rate of 39.6% for individuals, so few people form personal holding companies to shelter income from taxes. Nonetheless, there is a personal holding company tax equal to 20% of undistributed personal holding company income, equal to the total after-tax income minus the dividend deduction and calculated on Schedule PH, Form 1120.
A corporation will be classified as a personal holding company if it satisfies 2 requirements, which is checked annually:
- 60% of ordinary gross income consists of PHC income, which is basically defined as investment income: interest, dividends, rents, and royalties;
- 5 or fewer people own more than 50% of the fair market value of the stock, either directly or indirectly, during the last half of the year.
If there is a danger that it will be classified as a personal holding company, the penalty can generally be avoided by paying out all the undistributed after-tax income. Often, this tax is assessed for several years of income after an IRS audit. However, the tax, but not penalties and interest, can be avoided if a deficiency dividend is distributed within 90 days after an assessment that a PHC tax is owed for the previous year (IRC §547). The dividend is treated as being paid in the previous year in which it reduces the undistributed PHC income.