Accumulated Earnings Tax - Effect on Retained Earnings
The accumulated earnings tax (AET) is a penalty tax imposed on businesses that unreasonably accumulate earnings in the corporation rather than paying out dividends to their shareholders. If the Internal Revenue Service (IRS) deems that a corporation is accumulating income to avoid tax, a 20% tax will be imposed on the accumulated taxable income.
Withholding dividend distributions to avoid tax is a risky strategy that may lead to a costly accumulated earnings tax penalty from the IRS. Finding a balance between the retention of profits for the good of your business and staying compliant with IRS regulations is the best way to prevent problems in the future.
What Is the Accumulated Earnings Tax?
The accumulated earnings tax is a 20% tax—or penalty—that the IRS imposes on corporations that retain "excessive" earnings. This usually comes in the form of holding on to business earnings instead of paying out dividends to avoid income taxes at the shareholder level. The accumulated earnings tax exists to prevent companies from accumulating earnings and profits beyond their "reasonable needs" to sidestep income tax on their shareholders.
Why Are Accumulated Earnings So Important?
Companies may be inclined to hold on to accumulated earnings for two reasons: to avoid taxation on dividends and to gain higher stock price appreciation. The latter is beneficial to shareholders because capital gains are taxed at a lower rate than dividends. Strategizing capital gains and losses is one of the top tax planning strategies that small business owners use, but you may require professional help to find a cost-effective yet compliant way of maximizing your assets.
Letting companies accumulate earnings in excess of their needs is detrimental to the government because it loses income from taxes. Levying a 20% penalty tax causes one of two things to happen:
The government collects taxes from the company through the penalty tax.
The threat of a penalty motivates the company to issue dividends, allowing the government to collect tax from the company’s shareholders.
Negotiating the tax system to minimize your tax liability can be a minefield for small business owners who lack expert knowledge of the system. For this reason, many small business owners turn to experts in accounting services to handle their tax affairs and minimize the likelihood of problems with the IRS.
How Is Accumulated Earnings Tax Calculated?
The IRS defines accumulated taxable income as "the corporation's taxable income with various adjustments, minus the dividends paid deduction and the accumulated earnings credit."
As per the Internal Revenue Code §535, accumulated earnings are calculated as follows:
Accumulated earnings = sum of accumulated earnings at the beginning of the year + current accumulated earnings - dividends paid to shareholders.
The accumulated earnings tax is then calculated as follows:
Accumulated earnings tax = accumulated earnings x 0.2
Accumulated Earnings Credit
Small business owners should remember that AET is imposed according to an interpretation of intent. The IRS must decide if or why a corporation might be withholding funds other than for the "reasonable needs of the business."
A $250,000 minimum accumulated earnings credit is included within the term “reasonable needs” for most businesses. This means that corporations can accumulate up to that amount without explanation or being worried about paying the penalty tax. Businesses within the fields of accounting, actuarial science, consulting, engineering, health, law, and performing arts are subject to a lower amount of $150,000.
The IRS recognizes that accumulating more than these amounts doesn't mean that a company is accumulating earnings unreasonably. What counts as an unreasonable amount will depend on the nature of the business and its future plans.
The key to understanding what is a reasonable amount and what goes beyond that is one best left in the hands of professionals. Apart from being able to advise business owners on what could be considered a "reasonable" amount, tax professionals can help with the paperwork necessary to justify the “reasonableness” of any accumulated earnings in excess of the minimum credit.
How Does the IRS Determine the Purpose of Accumulated Income?
The IRS can determine the purpose of accumulated income by checking investments or personal loans made out to a shareholder. The IRS may investigate:
If it notices an unreasonable accumulation of business earnings by a corporation and the nonpayment (or underpayment) of dividends
Any investments a corporation makes that aren’t related to its business using undistributed profits
Personal loans given to a shareholder
Expenditure by the corporation that personally benefits a shareholder
The simple fact that a business accumulates earnings beyond its reasonable needs (and beyond the minimum credit) will be determinative of a purpose to avoid income tax unless the corporation can prove otherwise.
When Must Corporations Pay Dividends?
The accumulated income tax obliges corporations to pay out dividends when two conditions are met: when money is available and when there's no other reasonable business use for that money.
Accumulated earnings tax benefits the government as dividend income is taxed at the same rates as ordinary income. The tax rate will depend on each shareholder’s filing status and their total taxable income for the year. It ranges from 10-37% in 2024.
Corporations Exempt from the Accumulated Earnings Tax
Certain corporations are exempt from the accumulated earnings tax. These include:
Personal Holding Companies
Personal holding companies are corporations in which more than 50% of the value of the company’s stock is owned by five or fewer individuals. At least 60% of its adjusted ordinary gross income must come from passive sources.
Tax-Exempt Corporations
Corporations like nonprofits and private foundations are exempt from tax under Subchapter F of the tax code.
Passive Foreign Investment Companies
Passive foreign investment companies are foreign corporations whose income or assets meet either of two conditions:
A minimum of 75% of the corporation's gross income is "passive." Passive income refers to income derived from investments or other sources outside of regular business operations.
A minimum of 50% of the company's assets are investments. These investments earn revenue in the form of capital gains, earned interest, or dividends.
How Can Corporations Stay Compliant to Avoid an AET Penalty?
The following two strategies can help corporations avoid an AET penalty:
1. Document Your Business's Use of Accumulated Earnings
Accumulated earnings tax is often associated with tax evasion. However, the reality is that regular, law-abiding businesses can be caught out by not paying due diligence to their financial affairs. Corporations must therefore take preemptive action to avoid noncompliance and a costly penalty tax. This can be achieved by:
Contemporaneously documenting their intentions for accumulated earnings and/or investments
Paying sufficient dividends to shareholders
Being wary of making personal loans or non-dividend advances to shareholders that could be construed as avoiding paying dividends
2. Work with a Tax Professional
Working with a tax professional is the best way to stay compliant and avoid IRS penalties. Because each business is different in nature, it’s difficult (and unadvisable) to make decisions based on generic information. Having an expert by your side will help you stay on the right side of the law and optimize your tax savings.
Stay Compliant to Avoid IRS Penalties
The government keeps a close eye on accumulated earnings to identify possible instances of corporate tax evasion. Logically, when corporations retain their profits rather than paying them out as dividends, the government will want to know why.
You must establish a "reasonable need" for retaining your business earnings to stay compliant and avoid a potentially significant accumulated earnings tax penalty. Staying ahead of the game with the help of a tax professional is the most effective way to stay compliant, stay profitable, and avoid penalties from the IRS.
