You’re pleased with the 21 percent corporate tax rate (. The information below was provided to us from Bradford Tax Institute.

 

You’re pleased with the 21 percent corporate tax rate (thanks to the Tax Cuts and Jobs Act).

 

And you know that having your corporation pay you dividends with its after-tax profits subjects those profits to double taxation (once at the corporate level and again at your personal level).

 

But you’re happy that the dividend receives tax-favored capital gain treatment.

 

Okay, tax one at the corporate level and tax two at the personal level, not so bad.

 

But here’s a tax to make you mad. You may know of it and not think about it. Or you may not even know about it.

 

This tax, known as the accumulated earnings tax, is a penalty tax on the corporation that does well but doesn’t share its profits in a manner agreeable with the IRS.

 

Accumulated Earnings Tax

 

The accumulated earnings tax is a 20 percent corporate-level penalty tax assessed by the IRS, as opposed to the tax paid voluntarily when you file your 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 a Gripe—You Should Gripe About It, Too

 

Lawmakers enacted the $250,000 threshold in 1981, effective January 1, 1982. That was 40 years ago, and it has not been increased for inflation. Frankly, that’s outrageous

 

If you apply the consumer price index inflation calculator to that $250,000, your result is $774,910

 

But you don’t get to do that. Instead, you can face the 20 percent accumulated earnings tax if your accumulated earnings exceed $250,000 or a measly $150,000 if you are a personal service corporation

 

The 20 percent penalty tax targets small corporations, although it applies to all corporations, including publicly traded corporations.

 

What To Do

 

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, sell, 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

 

Triple Tax Example

 

Tim didn’t pay attention. His corporation accumulated $1 million in earnings.

 

The IRS arrives, sees the $1 million in accumulated earnings, and asks Tim, “Why does your corporation have that much money?” Tim has no good answer and ends up paying $150,000 in accumulated earnings tax.

 

 After the audit and writing the check, Tim has his corporation pay him a dividend of $600,000 to reduce the corporate accumulated earnings to the $250,000 safe harbor.

 

Here’s how Tim and his corporation suffered from the triple tax:

 

Corporate earnings $1,265,823

Tax at 21 percent -265,823

Accumulated earnings 1,000,000

Less safe-harbor -250,000

Excess earnings 750,000

Tax at 20 percent 150,000

Dividend to Tim 600,000

Tax on dividend 142,800

Triple tax amount $ 558,623

 

Two points here

 

First, had Tim’s corporation documented reasons for the $750,000 in accumulated earnings above the $250,000 safe harbor, there would have been no penalty tax or dividend distribution.

 

Second, although Tim suffers a 23.8 percent tax on his dividend because of his high income, this tax could increase significantly. In the not-too-distant old days, the tax code taxed dividends as ordinary income—that’s ugly, and it’s being talked about again.

 

The Road Is Clear

 

For Tim, you, and everyone who operates as a C corporation, don’t make the accumulated earnings tax low-hanging fruit for the IRS.

 

The solution is to identify the money needs of the corporation and put those numbers in the corporate minutes and business plans.

 

Takeaways

 

The 21 percent corporate tax rate may entice you to keep more money in your C corporation.

 

If your corporation’s accumulated earnings exceed $250,000 ($150,000 if you operate a personal service C corporation), you should (must is a better word) create a document that proves why you need the money inside the corporation rather than paying it out as dividends.

 

If you suffer the 20 percent accumulated earnings penalty tax, you paid an unnecessary tax—and suffered a triple tax:

 

• Tax on corporate income

 

• Tax on excess accumulated earnings

 

• Tax on dividend income

 

July 5, 2022 | DWHuff Consulting

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