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1996-11-06
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@081 CHAP 8
┌────────────────────────────────────┐
│ ACCUMULATED EARNINGS TAX │
└────────────────────────────────────┘
@IF119xx]NOTE FOR @NAME:
@IF119xx]
@IF119xx](The following discussion of the accumulated earnings tax is
@IF119xx]not particularly relevant for your business, which is a
@IF119xx]@ENTITY, and not a C corporation.)
@IF119xx]
@IF110xx](NOTE: Because your firm is organized as a C corporation, it
@IF110xx]is possible the accumulated earnings tax penalty described
@IF110xx]below could apply to @NAME.
@IF110xx]
@IF110xx]If so, you may want to consider electing S corporation status,
@IF110xx]in order to eliminate any further exposure to this "penalty
@IF110xx]tax" in the future.)
@IF110xx]
Because (federal) corporate income tax rates begin at only
15% on the first $50,000 of taxable income of a C corporation,
and only $22,250 on the first $100,000 of taxable income
(22.25%), it is tempting to accumulate as much income in
the corporation as possible at those low tax rates, rather
than pay out dividends (or even deductible salaries to
stockholders), which may be taxable at 31% to 39.6% tax
rates to the owners. The tax law has long provided for an
ACCUMULATED EARNINGS TAX on any such income accumulations
that are considered to be excessive.
Corporations are generally allowed to accumulate up to
$250,000 of undistributed earnings (only $150,000 for
certain professional service corporations) without any
questions from the IRS. Above this safe harbor, however, a
corporation must be able to justify the accumulation based
on the "reasonable business needs" of the company. If not
able to justify excessive accumulations, the corporation
becomes potentially subject to the accumulated earnings
penalty tax, which is 39.6% of the amount determined to be
"excessive accumulations."
Thus, while there are definite benefits to accumulating
some annual profits in a C corporation, one needs to be
wary of the accumulated earnings penalty tax, unless you
are able to demonstrate that the corporation is retaining
the capital because it needs to plow it back into the
business for working capital, expansion, etc.
The possibility of being hit by the accumulated earnings
penalty tax is one of the disadvantages of operating as a C
corporation. This is one less tax to worry about if you
remain unincorporated, or elect to operate your corporation
under Subchapter S (as an "S corporation").
┌───────────────────────────────────────────────┐
│ WAYS OF AVOIDING THE ACCUMULATED EARNINGS TAX │
└───────────────────────────────────────────────┘
While accumulating earnings in a C corporation can be a
worthwhile tax planning maneuver, you may find after a number
of years that you have accumulated several hundred thousand
dollars in the corporation, and that cash is coming out of
the corporation's ears. In that case, the corporation will
become an inviting target for an overeager IRS auditor who
wants to slap the corporation with a large accumulated
earnings penalty tax. Here are a few strategies for
avoiding (or getting out of) this bind:
. Elect S corporation status, where this is feasible,
as a last resort. S corporations are not subject to
the accumulated earnings tax.
. Reduce excess liquidity (too much cash, stocks and
bonds, etc.) in the corporation by plowing profits
back into the business, buying more equipment or
facilities. Consider having the corporation buy real
estate that it is currently leasing from a landlord
or prepay some of the debts of the corporation. Or,
if buying out another shareholder, let the corporation
redeem his or her stock, rather than buy it yourself
as an individual. Such a redemption will reduce
the corporation's excess liquidity AND (in part) its
accumulated earnings.
. Set up a reserve to redeem stock of a shareholder
(who has died) in order to provide cash for the
individual's estate to pay death taxes, funeral
expenses and other estate expenses. This reserve, if
properly documented, is like a debt that is allowed
as a reduction of the corporation's accumulated
earnings, in determining the amount of excessive
accumulated earnings.
. Create a fund to allow for a bona fide plan to replace
facilities or to expand the business, including an
acquisition of another business. Be sure to thoroughly
document these plans in your corporate minutes.
. Set up a reasonable reserve fund, if in manufacturing,
to pay potential uninsured product liability claims.
This reserve is not deductible in computing income
tax, but can be taken into account for purposes of
the accumulated earnings tax.
. Accumulate funds to retire indebtedness created in
connection with the business of the corporation.
. Establish a "defined benefit pension plan" with an
initial "past service liability" that must be funded
over a period of years.
@CODE: LS
In @STATE, any accumulated earnings are confiscated
by the State.
@CODE:OF