What Is the Section 531 Accumulated Earnings Tax?

The accumulated earnings tax is a penalty imposed on corporations that retain earnings beyond their operational needs. Its purpose is to discourage companies from holding profits to help shareholders avoid the income tax they would otherwise pay on dividends.

This tax is not one that companies calculate and pay on their own. Instead, the Internal Revenue Service (IRS) asserts the tax during an examination if it determines a corporation has been formed or used to avoid shareholder-level income tax.

Corporate Applicability

The accumulated earnings tax specifically targets C corporations. Under the two-tier tax structure for C corporations, the entity pays income tax, and shareholders are also taxed on dividends. By not distributing dividends, the second layer of tax at the shareholder level is deferred or avoided. The tax applies regardless of the number of shareholders a corporation has.

Certain corporations are exempt from this tax under Internal Revenue Code Section 532. These exemptions include personal holding companies (PHCs), foreign personal holding companies, and tax-exempt organizations. The tax also does not apply to pass-through entities like S corporations or partnerships, as their income is passed directly to the owners and taxed at their individual rates.

Identifying Reasonable Business Needs

The central issue is whether a corporation’s retained profits exceed its “reasonable needs of the business.” The IRS looks for evidence that the accumulations are for legitimate business purposes, which requires specific, definite, and feasible plans for the use of the retained earnings.

Valid business needs that can justify accumulating earnings include:

• Funds set aside for business expansion or to acquire a new plant or equipment.
• Purchasing another business.
• Retiring business-related debt.
• Redeeming stock from a deceased shareholder’s estate to cover death taxes and administrative expenses.

These plans must be documented with a level of detail that a prudent businessperson would require.

Another justifiable need for retaining earnings is to cover working capital for one full operating cycle. Courts and the IRS use a method known as the Bardahl formula to calculate the amount of working capital needed. This formula determines the length of a company’s operating cycle by adding the time it takes to turn over inventory and the time it takes to collect accounts receivable.

Conversely, certain actions are viewed by the IRS as indicators that accumulations may be unreasonable. Making loans to shareholders or for purposes that do not benefit the corporation is a red flag. Investing retained earnings in assets that are unrelated to the corporation’s primary business activities can also suggest an improper accumulation.

Calculating the Accumulated Earnings Tax

The calculation begins with the corporation’s taxable income for the year. This figure is then modified through a series of adjustments to more accurately reflect the company’s dividend-paying capacity.

To arrive at “adjusted taxable income,” certain items are subtracted from the initial taxable income figure. A deduction is for federal income taxes paid or accrued during the year. Some items must be added back, such as the dividends-received deduction, which is allowed to corporations that receive dividends from other domestic corporations.

From this adjusted taxable income, the corporation is allowed to subtract an “accumulated earnings credit.” This credit is the greater of two amounts: either the portion of current-year earnings retained for the reasonable needs of the business or a statutory minimum amount. For most corporations, the minimum credit is $250,000, while for certain personal service corporations in fields like health, law, and accounting, the minimum is $150,000.

The amount remaining after subtracting the dividends paid deduction and the accumulated earnings credit is known as “accumulated taxable income.” This is the final base on which the penalty tax is levied. The accumulated earnings tax is calculated at a flat rate of 20% of the accumulated taxable income. This tax is an additional penalty on top of the regular corporate income tax.