Avoid the Hidden Dangers of the Accumulated Earnings Penalty Tax

If you run your business through a regular “C” corporation, beware of the accumulated earnings tax (AET). 

The IRS can use the AET to penalize C corporations that retain earnings in the business rather than pay them to shareholders as taxable dividends. To retain earnings, the C corporation first pays the corporate tax of 21 percent on those earnings.

When the corporation distributes those already taxed earnings to shareholders, the shareholder includes those distributed earnings as dividends in taxable income, where they are taxed again at the shareholders’ capital gains rate.

The AET is a flat 20 percent tax. The AET is a penalty tax imposed after an audit in which the IRS concludes that the corporation paid out insufficient dividends compared to the amount of income accumulated by the corporation. 

You have AET exposure when your C corporation has large balances in retained earnings, cash, marketable securities, or loans to shareholders reported on a corporation’s balance sheet on IRS Form 1120, Schedule L.

The IRS can impose the AET on any C corporation, including public corporations. However, closely held C corporations are the most likely targets because their shareholders have more influence over dividend policy than public corporations’ shareholders.

Historically, IRS auditors have not prioritized the AET, but anecdotal evidence suggests this may change.

Fortunately, there are many ways to avoid problems with the AET—for example:

• Elect S corporation status
• Retain no more than $250,000 in earnings ($150,000 for corporations engaged in many types of personal services)—all C corporations are allowed to retain this much AET free.
• Establish that the corporation needs retained earnings above $250,000/$150,000 for its reasonable business needs—for example, to provide necessary working capital, fund expansion needs, pay debts, or redeem stock 

The key to avoiding the AET is to document the reasons for accumulating earnings beyond $250,000/$150,00 in corporate minutes, board resolutions, business plans, budget documents, or other contemporaneous documentation.

If you want to discuss the accumulated earnings tax, please call me on my direct line at 408-778-9651.