It is usually a good idea for a company to save money for a rainy day. Unfortunately, business owners can run into serious tax trouble if their corporations sock away too much cash. The tax trouble comes from the Accumulated Earnings Tax which is a tax on corporations buried in a little noticed Subchapter of the Internal Revenue Code. Although many businesses have tended to ignore this tax, the IRS is fully aware of it and is not shy about trying to impose it whenever it feels that "excessive" funds are being accumulated by a corporation. In fact, over the past few years, the IRS appears to be increasing its assertions of accumulated earnings issues in conducting corporate income tax audits.
Q: What is the Accumulated Earnings Tax ("AET")?
A: The AET is a "penalty" tax on certain corporations, as it is imposed in addition to any income tax to which a corporation is otherwise subject. For the 2012 tax year, the AET tax rate is 15%. But, unless Congress takes further action, the AET tax rate is scheduled to increase to 39.6% for tax years beginning on or after January 1, 2013.
Q: Which corporations are subject to the AET?
A: The AET is designed to discourage the use of a corporation as an accumulation vehicle to shelter its individual shareholders from recognizing income on corporate distributions in the form of dividends. Accordingly, subject to certain exceptions stated below, IRC Section 532 imposes an AET on every corporation "formed or availed of for the purpose of avoiding the income tax with respect to its shareholders, or the shareholders of any other corporation, by permitting earnings and profits to accumulate instead of being divided or distributed." Therefore, a corporation's liability for the AET typically turns on the intent of those shareholders who control the corporation. The case law in this area, although numerous, is not very useful as precedents because the factors on which the IRS will focus are objective manifestations of the shareholders' state of mind. Thus, each case is unique.
Q: Which corporations are not subject to the AET?
A: Under IRC Section 532(b), "Personal Holding Companies" (as defined in IRC Section 542), tax-exempt corporations (as defined in IRC Section 501), and "Passive Foreign Investment Companies" (as defined in IRC Section 1297), are not subject to the AET. Significantly, under IRC Section 1363(a), Subchapter S corporations are also not subject to the AET. Moreover, publicly held corporations are essentially exempted from the AET as a practical matter, since it is very difficult to establish a tax-avoidance purpose in the case of a widely-held operating company when no individual or small group of individuals typically has legal or effective control of the company so as to demonstrate that the corporation is being "formed or availed of" for the forbidden tax-avoidance purpose.
Q: What are the principal factors that the IRS and the Courts look at in determining whether the forbidden tax-avoidance purpose exists?
A: The Treasury Regulations under IRC Sections 531-537 provide that the following factors are indicative that a corporation's accumulations are not for the "reasonable needs of the business" and thus are evidence that it was formed or availed of for the forbidden tax-avoidance purpose:
Q: Are there any defensive measures that a corporation can take to counter the presence of one or more of these factors as evidence of the forbidden tax-avoidance purpose?
A: Yes. First and foremost, the corporation should keep contemporaneously prepared, detailed minutes of meetings of the board of directors. These meetings should be held no less frequently than annually. At these meetings, there should be a discussion of the "reasonable needs of the business" known at such time and why these may favor a corporation's retaining its cash reserves rather than distributing them to its shareholders. Some examples of "reasonable needs of the business" include (i) accrued income tax for the year, (ii) working capital needs, (iii) plans for expansion or asset purchases, (iv) stock redemptions, (v) pending debt retirement, and (vi) any specifically identifiable business contingences, including litigation involving the corporation.
Q: If a corporation's accumulation of its earnings and profits are determined to not be for the "reasonable needs of the business," is such a finding conclusive that the forbidden tax-avoidance exists?
A: Not necessarily. IRC Section 533(a) provides that the fact that the corporation's earnings are permitted to accumulate beyond the "reasonable needs of the business" shall be determinative of the purpose to avoid shareholder income taxes UNLESS the corporation proves to the contrary by a preponderance of the evidence. However, this presumption does mean that most of the cases in this area have been decided on the basis of whether a corporation can demonstrate that the accumulations were necessary for the corporation's "reasonable business needs of the business." This presumption is especially difficult to overcome since the U.S. Supreme Court in U.S. v. Donruss Co., 393 US 297 (1969) has held that the forbidden tax-avoidance purpose need only one of the purposes for the accumulation, not the sole or dominant purpose for the accumulation.
Q: If the forbidden tax-avoidance purpose is found to exist, how is the AET applied?
A: If it is determined that a corporation is subject to the AET for a particular year, IRC Section 531 imposes the 15% AET tax on the "Accumulated Taxable Income" of the corporation for the year involved. "Accumulated Taxable Income" is based on the corporation's taxable income after certain adjustments. One of these adjustments, the "Accumulated Earnings Credit", allows a reduction in taxable income for the amount needed to cover the reasonable needs of the business for the year. This adjustment, and the other adjustments enumerated in IRC Section 535, is intended to highlight the portion of the current year's earnings that have been accumulated beyond the reasonable needs of the business for the year.
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