Understanding the Accumulated Earnings Tax Before Switching To a C Corporation in 2019

The June 2018 Penn Wharton Budget Model survey indicated that over 235,000 business owners are projected to convert their pass-through businesses to C corporations.  Their primary motivation is to take advantage of the new 21% corporate tax rate under the 2018 Tax Cuts and Jobs Act.  This is particularly important for business owners who can’t fully benefit from the new Qualified Business Income deduction. In fact, the biggest switchers are owners of specified service businesses whose taxable income exceeds $415,000 for married filing jointly filers.

Although the new 21% rate is tempting, C corporations are subject to double taxation. Corporate income is taxed once at the entity level and again when it is distributed to shareholders as dividends. This can be avoided if the corporation retains all of it’s profits to finance growth.  However, this opens the door to the Accumulated Earnings Tax (AET) if profits accumulate beyond the reasonable needs of the business.

The AET is a penalty tax imposed on corporations for unreasonably accumulating earnings. The tax rate on accumulated earnings is 20%, the maximum rate at which they would be taxed if distributed.  The tax is in addition to the regular corporate income tax and is assessed by the IRS, typically during an IRS audit. There is no IRS form for reporting the AET. If imposed, the earnings are subject to triple taxation when eventually distributed to the shareholders. Once at the entity level, then when the AET is imposed and finally when the accumulated earnings are distributed to shareholders.

The AET applies when there is intent to avoid income tax at the shareholder level by accumulating earnings in the corporation. The AET applies even when tax avoidance is not the main reason for the accumulation of income but is only one of several reasons.  Keep in mind the IRS allows for an accumulated earnings credit of $250.000 or $150,000 if you are taxed as a Personal Service Corporation. Therefore, once your retained earnings exceed those limits you need to be concerned about the AET and document why your corporation needs accumulated earnings exceeding that amount.

The fact that a corporation is a holding or investment company is automatically considered evidence of the existence of a tax avoidance purpose unless the corporation can establish it wasn’t formed to avoid tax. A holding company is a corporation in which there is practically no activity other than the holding of investment property. An investment company is one that buys and sells stock, securities, real estate, and other investment property, in addition to holding investment property. If the corporation is not a holding or investment company, a tax avoidance motive is considered present if the corporation has accumulated earnings and profits in excess of the reasonable needs of the business unless it can prove otherwise by a preponderance of the evidence. The IRS regulations identify the following situations that may indicate accumulations beyond the reasonable needs of the business exist:

  1. Loans to shareholders or related parties.
  2. Payments by the corporation that personally benefit the shareholders.
  3. Investments in assets having no reasonable relationship to the corporation’s business.
  4. A weak dividend history.
  5. Retention of earnings to provide against unrealistic hazards.
  6. Working capital levels that appear high in relation to the needs of the business.

7. Salaries paid to shareholder/employees that are either extremely high (avoiding corporate  

     income tax) or extremely low (avoiding shareholder income and employment tax).

The AET is not assessed if accumulated earnings are reasonable in light of business needs. This subjective test can be satisfied by a variety of business reasons including retaining earnings to satisfy the reasonably anticipated future needs of the business.  The IRS regulations provide some broad criteria that can be used to justify that earnings are being accumulated for reasonable business needs. These include:

  1. Providing for a business expansion or plant replacement.
  2. Acquiring a business enterprise through purchasing stock or assets.
  3. Facilitating the retirement of company debt created in connection with its trade or business.
  4. Providing necessary working capital for the business.
  5. Providing for investments in suppliers, or loans to customers or suppliers to maintain the business of the corporation.

6. Providing for contingencies such as the payment of reasonably anticipated losses such as an

    actual or potential lawsuit, loss of a major customer, or self-insurance.

The accumulated amount does not have to be used immediately or within a short period after the close of the tax year, so long as it will be used within a reasonable time depending on all the facts and circumstances relating to the future needs of the business.   

To avoid the AET which is 20% of “accumulated taxable income”, a corporation must be able to demonstrate to the IRS that its accumulations are necessary to meet its business needs. The corporation must have sufficient facts and documentation to substantiate that the plans for present and future business needs require additional funds. A determination of whether the accumulation of earnings and profits is a reasonable business need is based on the facts and circumstances of each case. 

The dramatic reduction in the corporate tax rate from 35% to 21% has sparked renewed interest in the AET. Although it remains to be seen whether flow-through entities will rush to covert to C corporations, those that do will need to pay attention to this tax.  Conversion may be the way to go if owners have no need for distributions and the corporation avoids the AET by proving its accumulations are for the reasonable needs of the business.

If you have any questions, please call Gregory J. Spadea at 610-521-0604.

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