IRS Use of Accumulated Earnings Tax May Increaseby
As we approach mid-2021, political discussions are focused on raising more tax revenue, particularly from the wealthy.
Our system imposes a 20 percent tax on accumulated taxable income of a corporation “availed of” to avoid tax to shareholders by permitting earnings and profits to accumulate rather than being paid out. (See Sec. 531, 532 535). The risk of incurring such tax is usually associated with the closely-held company, but there is per se no exemption for even the public company. The tax applies to any corporation, any C corporation, foreign or domestic, with few exceptions (Regs. 1.532-1(a)(1).
When the tax is asserted, the beginning point in the calculation is current taxable income (Section 535). So, despite the use of “accumulated” in describing the tax, the emphasis remains on taxable income for a particular year. Income tax elections may also impact this tax.
Taxable income is the focus, although there are adjustments with respect to deductions for charitable donations, net operating losses, the dividend-received deduction and capital gains and losses. There are sundry details as to deductions, as with practically any tax. And there is permitted, usually, a $250,000 minimum accumulation of earnings.
The main focus in an IRS proposal of tax here is usually the accumulated earnings credit, which for other than a mere holding or investment company, primarily turns on the “reasonable needs of the business” (Section 535(c’)(1). The accumulated earnings tax doesn’t apply to earnings kept in the business to meet the reasonable needs of the business.
The key term, “reasonable needs of the business,” is so subjective in nature that the tax itself is de facto raised by the IRS. This tax is raised and imposed by the IRS, whereas the personal holding company tax is basically mechanical. The PHC tax is self-imposed. When the PHC tax applies, there is relief from the accumulated earnings tax (Section 532(a), (b)(1).
Given the “reasonable needs of the business” part of the tax calculation, put ten around a table to figure the tax, you’d likely get ten different answers. You may get more than 10 answers if you asked those 10 people to calculate the tax over two days. The burden of proof re accumulations beyond the reasonable needs of the businesses may fall on the IRS (Section 534, Regs. 1.534-2; see also sections 532, 533, 535, 537).
Why This Tax May Get More Emphasis
As we approach mid-2021, political discussions are focused on raising more tax revenue, particularly from the wealthy. The details include:
- raising income tax rates
- major increases in taxation of large capital gains
- eliminating tax-free treatment for some exchanges of realty
- reduced access to the 20 percent of business income deduction for the wealthy
- major increases in social security taxes
- reduced access to itemized deductions
- less beneficial treatment with respect to 401(k)’s and IRA’s for the wealthy
- reduced access to the long-established basis step-up for appreciated property at death
- major increases in gift, estate and generation-skipping transfer tax
The current administration is also hiring more and more IRS auditors. The most commonly reported theme is the administration needs $80 billion in funding of the IRS, which is to translate into $700 billion of increased tax revenue over 10 years.
There is tax-raising momentum that focuses significantly on the wealthy and C corporations. Increased taxation of the wealthy shareholder may put pressure on the corporation to refrain from paying dividends, which per se might increase the IRS focus on the accumulated earnings tax.
Under current law, the tax on dividends can reach an incremental 20 percent. Reports are that the Biden proposals could increase the tax on dividends, for the wealthy, to 39.6 percent compared to the current 20 percent. Plus, there is the 3.8 percent tax that can apply to higher levels of investment income (Sec. 1441).
There may well be added circumstances that suggest retaining income in the C corporation rather than paying dividends, which is a factor that might suggest the accumulated earnings tax to the IRS auditor.
What Section 531 Planning Does This Suggest?
Does the author know the IRS will increasingly attack C corporations with an emphasis on the accumulated earnings tax? No. In this environment, should tax planners consider at least rudimentary planning with respect to the Section 531 tax? Yes. Following are some suggestions for the tax planner and the corporate owner/executive to consider.
The minimum accumulated earnings credit generally allows $250,000 of accumulated earnings and profits at the close of the previous year. This amount is reduced to $150,000 in the case of a corporation, the principal function of which is performing services in the field of health, law, engineering, architecture, actuarial science, performing arts, or consulting (Sec. 535(c)(2).
Are the books and records sufficiently accurate in so far as measuring accumulated earnings and profits? Is the accumulated earnings credit not as large as one might expect considering that the credit is allocated among controlled corporations? (Sec. 535(c’)(5).
As discussed, the accumulated earnings tax does turn on taxable income, with adjustments. Decisions reducing taxable income may want to consider the issue of the accumulated earnings tax, if it is a realistic concern. One generally needs a perspective of adjustments to taxable income that go into the computation of the accumulated earnings tax.
Among the adjustments not yet mentioned is the income tax itself (Sec. 535(b)(1). Projections may also want to factor in the prospect of increased corporate tax rates. The Biden Administration’s proposals include increasing the corporate tax rate from 21 percent to 28 percent.
Elections, such as maximizing the expensing of equipment additions, may be considered from the standpoint of income tax savings and potentially reducing exposure to the accumulated earnings tax. One of the practical difficulties here is that the income tax consequences of a decision may be easily quantified whereas the accumulated earnings tax is more of a risk, a contingency.
Can our asset allocations (passive, business, etc.) affect the corporation’s exposure to the tax? Obviously yes, as one reads these provisions, but the issues quickly become difficult.
The most difficult elements of our topic flow from the issue of intent. The IRS Manual on this tax states in “Indicators of Intent”:
“ (1) A prerequisite to imposition of the IRC 531 tax has been that the corporation be formed or availed of for the purpose of avoiding the income tax on its shareholders. As purpose involves a state of mind or intent, it is necessary to look at the surrounding facts and circumstances in each individual case to determine whether the purpose of the accumulated earnings was to allow the shareholders to avoid the income tax or for some other purpose….”
The manual goes on to discuss dealings between the corporation and shareholder, including loans and expenditures that benefit the shareholder; investments in assets having no reasonable connection with the corporation’s business, and the corporation’s history of paying (or not paying) dividends (Internal Revenue Manual, 22.214.171.124.2 (3-16-2015), https://www.irs.gov/irm/part4/irm_04-010-013).
It also states:
“Examiners should consider that IRC 543 provides that earnings permitted to accumulate beyond the reasonable needs of the business shall be "determinative" of the purpose to avoid shareholder's income taxes unless the corporation shall prove to the contrary by a preponderance of the evidence. By virtue of this provision, most cases have been won or lost on the battleground of reasonable business needs.” (Internal Revenue Manual, 126.96.36.199.4 (3-16-2015), https://www.irs.gov/irm/part4/irm_04-010-013).
The list of particulars discussed include: whether expansion of a business is bona fide, reasonableness of stated goals of retiring debt, buying another company, necessary working capital, suppliers who need loans, financing employee benefit plans, possible loss of a principal customer, working capital needs, etc. The IRS Manual tells the IRS auditor in evaluating a proposed accumulated earnings tax to review the minutes “for a discussion on why the funds are being accumulated (e.g., plans for plant expansion, debt retirement, inventory increases, etc.).”
Statements in board minutes as to detailed, substantive reasons for retaining assets in the corporation are often recommended in this regard. But keep in mind substance, reasonableness, believability and proof of intent.
Tax advisors and C corporation business owners need to include the accumulated earnings tax topic in their planning. Even if there is no intent to use the C corporation to avoid income tax to shareholders, in many corporations, work needs to be done to prove the reasons for retaining funds in corporate solution.
It is quite possible to incur the tax when there were substantive reasons for retaining corporate funds, but those reasons weren’t documented in a timely manner.
Mike Pusey, CPA served as National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in...