Owners of regular C corporations face double taxation. The company’s profits are subject to the corporate income tax. If some of those profits are paid to the owner and other shareholders, as nondeductible dividends, the same dollars will be taxed again, on the recipients’ personal tax returns.
Double taxation might not have been a major concern when the highest tax rate on qualified dividends was only 15%, as it had been for most of this century. However, recent legislation boosted the dividend tax rate to 20% for some taxpayers; high-income taxpayers also may owe the 3.8% Medicare surtax as well as some indirect taxes on dividends they receive. Therefore, business owners may prefer to retain earnings in the company, rather than pay out double taxed dividends.
Example 1: Craig Taylor owns 100% of CT Corp. The company’s profits this year are $400,000, on which CT Corp. pays income tax. Rather than pay himself a dividend, which would be taxed at an effective rate of 25% in this scenario, counting all the various taxes that would be triggered, Craig decides to keep the money inside CT Corp.
However, CT Corp. might run into a tax problem: the accumulated earnings tax (AET). Retained earnings over $250,000 are subject to this tax ($150,000 for personal service corporations, such as professional practices). Thus, if CT Corp. had $200,000 in retained earnings from prior years, this year’s $400,000 makes the total $600,000, which is $350,000 over the $250,000 limit. CT Corp. would owe tax on the $350,000 overage: $70,000, at the current 20% AET rate.
In practice, the AET is not a certainty. The IRS might investigate when CT Corp. reports retained earnings over $250,000 on its corporate income tax return, but it’s possible that it won’t owe the AET, if the company has a good reason for the large accumulation.
Earnings in excess of $250,000 will be permitted if the company can show that it had a reasonable need for holding onto cash and other liquid assets. That need could be to provide funding for a specific plan related to the company’s business, such as buying expensive equipment or expanding into a new territory.
In order to retain earnings over $250,000, yet avoid the AET, a corporation must be able to show that there really was a plan in place to use the money, and that the reasons for the retention go beyond tax avoidance. Ideally, corporate minutes or other documentation, such as emails, will include a discussion of, for example, the company’s intent to upgrade its information technology with an expensive new system.
No matter how well you can show that a plan was in place as a reason for accumulating excess assets, you’ll also need to show that the plan has since been executed, or is in some stage of progress.
What’s more, court decisions have approved the concept that C corporations can cite working capital as a reason for accumulating earnings over $250,000. Our office can help you determine an acceptable level of working capital for your company, which might raise its permissible level of accumulated earnings.
Regardless of your needs for working capital, there are basic steps you can take to avoid or limit the AET. For instance, you can pay some dividends to shareholders each year, even if that generates double taxation. A company that retains excess earnings while never paying out dividends may be especially vulnerable to IRS scrutiny and assessment of the AET.