A corporation can accumulate its earnings for a possible expansion or other bona fide business reasons. However, if a corporation allows earnings to accumulate beyond the reasonable needs of the business, it may be subject to an accumulated earnings tax of 15%. If the accumulated earnings tax applies, interest applies to the tax from the date the corporate return was originally due, without extensions.
The accumulated earnings tax is imposed on regular C corporations whose accumulated (retained) earnings are in excess of $250,000 if improperly retained instead of being distributed as dividends to (high tax bracket) shareholders.
To determine if the corporation is subject to this tax, first, consider the following:
- Regular corporations are entitled to $250,000 of (lifetime) accumulated earnings.
- Personal service corporations are entitled to only $150,000 of (lifetime) accumulated earnings.
- The accumulated earnings tax is not imposed on personal holding companies (PHCs), tax-exempt corporations, or passive foreign investment corporations.
In determining if the corporation has accumulated earnings and profits beyond its reasonable needs, value the listed and readily marketable securities owned by the corporation and purchased with its earnings and profits at net liquidation value, not at cost.
Reasonable needs of the business include the following.
- 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.
The absence of a bona fide business reason for a corporation's accumulated earnings may be indicated by many different circumstances, such as a lack of regular distributions to its shareholders or withdrawals by the shareholders classified as personal loans. However, actual moves to expand the business generally qualify as a bona fide use of the accumulations.
The fact that a corporation has an unreasonable accumulation of earnings is sufficient to establish liability for the accumulated earnings tax unless the corporation can show the earnings were not accumulated to allow its individual shareholders to avoid income tax.
