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
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:
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:
From this same regulation, the IRS lists the following as likely unreasonable reasons for accumulating the earnings:
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.
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:
July 5, 2022 | DWHuff Consulting
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