What Is the Retained Earnings Tax for C-Corporations?
Understand the tax implications for a C-corporation's retained earnings. Learn to balance funding future growth with avoiding a potential penalty tax.
When a business generates a profit, it can distribute those earnings to its owners or reinvest them back into the company. This reinvestment, known as retained earnings, is a common way to finance future growth. While retaining profits is a standard business practice, it can attract scrutiny from tax authorities. If a corporation accumulates earnings beyond what it can justify for its operational requirements, it may face a penalty tax designed to prevent the indefinite deferral of taxes that would otherwise be paid by shareholders on distributed profits.
Understanding the Accumulated Earnings Tax
The term “retained earnings tax” refers to what the Internal Revenue Code calls the Accumulated Earnings Tax (AET). This is not a tax on a company’s general retained earnings, but a penalty assessed when a corporation holds onto profits beyond its legitimate business needs to help shareholders avoid personal income tax on dividend payments. This tax applies exclusively to C-corporations, as profits from S-corporations, partnerships, and sole proprietorships pass directly to the owners’ personal tax returns.
The AET is a flat 20% tax levied on “accumulated taxable income” for the year and is imposed in addition to the regular corporate income tax. The IRS can impose the AET on any C-corporation, but closely held corporations are the most frequent targets because shareholders in such companies have significant influence over dividend policies. An IRS audit is the usual trigger for an AET assessment.
Justifying Earnings Retention for Business Needs
The primary defense against the Accumulated Earnings Tax is demonstrating that the retained funds are necessary for the reasonable needs of the business. These justifications must be specific, definite, and feasible, not merely vague possibilities.
One of the most common justifications is the need for working capital to cover the costs of a single operating cycle. Businesses can use a calculation, often referred to as the Bardahl formula, to estimate the amount of cash required to manage inventory, accounts receivable, and accounts payable. Other accepted reasons for retaining earnings include specific plans for business expansion, the acquisition of business assets like machinery, or the retirement of business-related debt.
The key to defending these needs is meticulous documentation. Corporations should formalize their plans in official records, such as board of directors meeting minutes, detailed business plans with financial projections, and internal budget documents. This evidence shows that the company had a clear purpose for accumulating the funds.
Calculating the Potential Tax
The calculation of the Accumulated Earnings Tax begins with the corporation’s taxable income for the year. This figure is then adjusted to more accurately reflect the company’s dividend-paying capacity. For instance, certain deductions allowed for regular income tax, like a net operating loss deduction, are disallowed, while some non-deductible items, such as federal income taxes paid, are subtracted to arrive at “adjusted taxable income.”
From this adjusted amount, a corporation can subtract the Accumulated Earnings Credit. For most corporations, there is a minimum credit of $250,000, meaning a company can accumulate up to this amount without providing a specific business justification. For certain personal service corporations, such as those in the fields of health, law, or accounting, this minimum credit is reduced to $150,000.
A corporation is not limited to the minimum credit amount and can claim a larger credit if it can prove that a higher amount is being retained for reasonable business needs. The credit is the greater of the minimum statutory amount or the amount substantiated by documented needs. After subtracting the credit and any dividends paid to shareholders, the remaining amount is the “accumulated taxable income” subject to the 20% tax.
Reporting the Accumulated Earnings Tax
Should a corporation determine that it is liable for the Accumulated Earnings Tax, the liability is reported and paid with its annual income tax return. The specific form used for this purpose is Schedule J (Form 1120), which is attached to the main corporate tax return, Form 1120.
Payment of the AET is due by the original due date of the corporate tax return, without regard to any extensions for filing. Interest on the AET liability begins to accrue from this original due date if the tax is not paid on time.