Editor: Mo Bell-Jacobs, J.D.
The accumulated earnings tax is a 20% penalty that is imposed when a corporation retains earnings beyond the reasonable needs of its business (i.e., instead of paying dividends) with the purpose of avoiding shareholder-level tax (seeSec. 531). In periods where corporate tax rates were significantly lower than individual tax rates, an obvious incentive existed for corporations to allow earnings to accumulate instead of paying dividends to their shareholders. While that particular disparity no longer exists, the law known as the Tax Cuts and Jobs Act of 2017, P.L. 115-97, lowered corporate-level tax rates significantly from 35% to 21%. As a result, the IRS could view this decrease in corporate-level tax rates as an incentive for companies to retain their earnings (or place them in unrelated investments) instead of paying dividends to shareholders.
Recent petitions before the U.S. Tax Court, as well as the authors' own observations, suggest the IRS is indeed stepping up its enforcement efforts with respect to the accumulated earnings tax (see Alta Peruvian Lodge Ltd.,No. 22821-21, petition filed Sept. 15, 2021, and Ban & Bhat Enterprise Inc., No. 27899-21, petition filed Oct. 22, 2021). The accumulated earnings tax can be a trap for the unwary, especially for profitable companies unaccustomed to documenting how they will use their earnings, forming policies for paying dividends, or outlining how their investments relate to their business. Companies should understand how to protect themselves against a potential IRS enforcement action.
Evidence of a purpose to avoid shareholder income tax
Generally, the accumulated earnings tax is imposed on any corporation formed or availed of for the purpose of avoiding shareholder-level income tax by permitting earnings to accumulate instead of being distributed to shareholders (see Sec. 532(a)). Whether a purpose exists to avoid income tax on the shareholders is a subjective determination based upon all of the facts and circumstances. Factors that could indicate evidence of a purpose to avoid income tax include, without limitation, the following:
- An unreasonable accumulation of earnings by the corporation and nonpayment (or insufficient payment) of dividends;
- The investment by the corporation of undistributed earnings in investments not related to its business; or
- A personal loan by the corporation to a shareholder or expenditures by the corporation for the personal benefit of a shareholder (see Regs. Sec. 1.533-1(a)(2)).
The fact that a corporation accumulates earnings beyond the reasonable needs of its business is determinative of a purpose to avoid shareholder income tax unless the corporation proves to the contrary by a preponderance of the evidence (see Regs. Sec. 1.533-1(a)(1)).
The unreasonable accumulation of earnings and nonpayment of dividends
A corporation's accumulation of earnings must not exceed an amount appropriate for the reasonably anticipated future needs of its business; otherwise, this may indicate a purpose to avoid shareholder income tax. To demonstrate that its accumulation of earnings is for the needs of the business, the corporation must have specific, definite, and feasible plans for how it intends to utilize its earnings in business operations (see Regs. Sec. 1.537-1(b)(1)). Thus, a corporation must show that it intends to use its earnings for a valid business purpose. Ideally, a corporation should contemporaneously document its intended use of accumulated earnings instead of waiting until the IRS raises the issue in an examination (e.g., through a budget or similar business plan).
First, a corporation should determine how much cash (or working capital) it needs to operate its business. One approach, known as the Bardahl formula, is to calculate the costs of running the business for one operating cycle (see Bardahl Manufacturing Corp., T.C. Memo. 1965-200; Bardahl International Corp., T.C. Memo. 1966-182). Broadly speaking, the corporation calculates the time, expressed as a percentage of a year, needed to complete one operating cycle (e.g., to produce inventory, effect sales, collect from customers). It then multiplies this percentage by its total operating costs for the year to arrive at an estimate of its operating costs for one cycle. The result, an estimate of its working capital needs, is then compared to its accumulated earnings balance at year end. The IRS typically uses the Bardahl formula as a starting point for determining if a corporation's accumulation of earnings may be unreasonable. It is not, however, the only method for a corporation to estimate its working capital needs. Adjustments to this calculation or other methods may be appropriate.
Next, a corporation should determine how it will use any earnings accumulated in excess of its working capital needs. Common (but not exclusive) additional reasons for a corporation to accumulate its earnings include: (1) acquiring or replacing plant, property, and equipment; (2) expanding operations or making strategic acquisitions; (3) adding to business hazard reserves; (4) adding to product liability loss reserves; and (5) paying taxes.
Example 1: X has been a profitable business for several years. At the end of year 1, it had $100 of accumulated earnings, $40 of which will be paid as a dividend. Using the Bardahl formula, X estimated it will cost $25 cash to complete an operating cycle. In its budget, X set aside $35 of cash to finance acquisitions it is actively investigating. If the IRS inquires about X's accumulation of earnings in an examination, X's contemporaneous documentation can demonstrate that it had specific, definite, and feasible plans for the use of the $100 of accumulated earnings either in its business or to pay dividends.
If a profitable corporation accumulates earnings beyond the reasonable needs of its business, it may need to consider paying dividends to its shareholders. Otherwise, the IRS could argue the corporation has a purpose to avoid shareholder-level tax. A corporation is well served by outlining a policy or documenting a plan for paying dividends.
Example 2: X is a successful business that has consistently earned a profit. The board of directors approved a regular dividend policy based upon X's available earnings. X's annual payment of dividends per its dividend policy is a factor tending to demonstrate there was not a purpose to avoid shareholder-level income tax.
Holding significant investments unrelated to the business
Investing accumulated earnings in bonds, equities, or other investments unrelated to the business could be considered evidence that a corporation has chosen to earn passive returns on its earnings instead of paying dividends to shareholders. Nevertheless, companies commonly hold investments for legitimate business reasons unrelated to the avoidance of shareholder-level income tax. For that reason, a corporation should document how its reasons for holding investments are connected to its business needs.
Example 3: Each year, X invests a portion of earnings in a combination of bonds and equities. Per its investment policy, X makes these investments in order to protect its earnings against inflation, fund its employee compensation plan, and generate the capital it needs to expand its business into similar product lines. X's contemporaneous documentation connecting how its investments relate to its business would tend to mitigate an argument that it was avoiding paying dividends to shareholders.
Loans to and expenditures on behalf of shareholders
A nondividend payment by a corporation out of its surplus earnings may be viewed by the IRS as evidence of a purpose to avoid shareholder-level income tax. Personal loans to shareholders or payment of a shareholder's personal expenses could suggest an intent to transfer corporate earnings to shareholders while avoiding the income tax on dividends (see Regs. Sec. 1.533-1(a)(2)(i)). In the context of a closely held corporation, a loan or advance of accumulated earnings to other commonly owned businesses of the shareholder(s) could also be viewed as evidence that the corporation is attempting to avoid payment of dividends to its shareholders (see, e.g., Cummins Diesel Sales of Oregon, 207 F. Supp. 746 (D. Or. 1962), aff'd 321 F.2d 503 (9th Cir. 1963) (interest-free loans to other corporations owned by shareholder constituted avoidance of shareholder-level income tax)).
Document accumulated earnings' use
The accumulated earnings tax can be a hidden penalty tax on highly profitable corporations that allow their earnings to accumulate without paying adequate (or any) dividends to their shareholders. In light of recent IRS enforcement efforts, corporations should take action to defend against the potential imposition of the accumulated earnings tax. Specifically, corporations can guard against any such action both by contemporaneously documenting how they will use their accumulated earnings and investments and by paying sufficient dividends to shareholders. Further, corporations should be mindful that personal loans or nondividend advances made to shareholders or other commonly owned businesses out of surplus earnings could suggest that the corporation is avoiding paying dividends to its shareholders. Taxpayers should consult a tax adviser to determine how (and whether) the points raised in this item apply to their specific situation.
Mo Bell-Jacobs, J.D., is a senior manager with RSM US LLP.
For additional information about these items, contact Eric.Brauer@rsmus.com and Mark.Schneider@rsmus.com.
Unless otherwise noted, contributors are members of or associated with RSM US LLP.