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What Is the Accumulated Earnings Tax?
The accumulated earnings tax is a tax imposed by the U.S. government on corporations with retained earnings that are deemed to be excessive. As the Internal Revenue Service explains, “The purpose of the accumulated earnings tax is to prevent a corporation from accumulating its earnings and profits beyond the reasonable needs of the business for the purpose of avoiding income taxes on its stockholders.”
Key Takeaways
- Corporations may have to pay an accumulated earnings tax to the federal government if they retain an excessive amount of their earnings and profits rather than using the money for shareholder dividends.
- For a corporation to avoid liability for the tax, the amount of its accumulated earnings and profits must not exceed the “reasonable needs of the business.”
- The IRS exempts a certain amount of accumulated earnings and profits from the tax, and it recognizes a long list of items that can qualify as “reasonable needs.”
- The purpose of the accumulated earnings tax is to discourage corporations from retaining earnings simply for tax avoidance purposes.
- The accumulated earnings tax rate is 20%.
How the Accumulated Earnings Tax Works
Corporations that accumulate earnings and profits above a certain level, instead of distributing them as taxable dividends to their shareholders, can be subject to the accumulated earnings tax. The level at which accumulated earnings become excessive depends on the “reasonable needs” of that particular corporation.
By law, corporations are not required to pay dividends, and many do not, especially if their goal is growing the business rather than producing regular dividend income for shareholders. For example, the IRS notes, “a corporation can accumulate its earnings for a possible expansion or other bona fide business reasons.” Tax avoidance, however, is a different matter.
For that reason, any liability for the accumulated earnings tax is based on two conditions. In addition to accumulating more earnings and profits than are justifiable based on its needs, “There must be an intent on the part of the corporation to avoid the income tax on its stockholders by accumulating earnings and profits instead of distributing them,” the IRS says.
The accumulated earnings tax rate is 20% of the company’s accumulated taxable income for that year (or years). The IRS defines accumulated taxable income as “the corporation’s taxable income with various adjustments, minus the dividends paid deduction and the accumulated earnings credit.”
The minimum accumulated earnings credit is generally “the amount by which $250,000 exceeds the accumulated earnings and profits at the close of the preceding year,” according to the IRS. In other words, a company with up to $250,000 in accumulated earnings and profits is assumed to be within the limits for “reasonable needs.” (A lower number, $150,000, applies to businesses “whose principal function is performing services in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and the performing arts.”)
However, “accumulation in excess of the $250,000 minimum credit is not an indication of an unreasonable accumulation,” the IRS says, and the law sets no maximum credit. The maximum, according to the IRS, “is the amount of current earnings and profits retained for the reasonable needs of the business (adjusted for net capital gains).”
“These adjustments are made primarily for the purpose of arriving at an amount that corresponds more closely to financial reality and thus, measures more accurately the corporation’s dividend paying capacity for the year,” the IRS explains.
The Reason for the Accumulated Earnings Tax
The accumulated earnings tax benefits the government by forcing corporations to pay out dividends when they have the money available to do so and no other justifiable uses for that money—or face a 20% penalty.
In the U.S. tax system, the dividend income that shareholders receive is taxed at the same rate as their earned income. Depending on their total taxable income for the year and their marital status when they file, that can range from 10% to 37%. (This applies to so-called ordinary dividends, the kind that corporations generally distribute.)
On the other hand, if the corporation simply retains that money, the shareholder won’t face any tax consequences unless they sell their shares, possibly many years later. In addition, when they do sell, they’ll owe tax on any profit they make at the more favorable rate for capital gains. For most people, that rate will be 15% or less, compared with as much as 37% for dividends.
Exemptions to the Accumulated Earnings Tax
In addition to exempting a certain amount of earnings on the basis of “reasonable needs” for companies that are subject to the accumulated earnings tax, the law exempts several types of companies from the tax altogether. Those are:
What Does the IRS Mean by “Reasonable” Business Needs?
In instructions to its tax examiners, the IRS provides a long list of items that may qualify as reasonable justifications for accumulating capital, noting that even that list is “not exclusive.” Among them: expansion, acquisition of another business, paying off debt, providing working capital, and funding a reserve to cover risks such as potential litigation.
What Are Retained Earnings?
Retained earnings refers to the amount of money a corporation has left over from its net income after paying any dividends to its shareholders.
How Are Stock Dividends Taxed?
Shareholders who receive dividends on stocks they own must report them on their income tax return for the year and pay tax on them at the same rate as their ordinary income. This is also true if shareholders elect to reinvest their dividends in additional shares of that stock rather than taking the money in cash.
The Bottom Line
When corporations pay dividends to their shareholders, the government receives a cut in the form of income taxes paid by those shareholders. If corporations decide to retain their earnings and profits instead of paying out dividends, the government may want to know why. If the business can establish that it has a “reasonable need” for doing so, that can be acceptable. However, if a company’s motivation appears to be tax avoidance, it can be subject to an accumulated earnings tax of 20%. More information on the accumulated earnings tax is available online in IRS Publication 542.