8960 / What is the accumulated earnings tax that a C corporation may be subject to? When does the tax apply?

Editor’s Note: The 2017 tax reform legislation limited the members of a controlled group of corporations (the members of which are determined as of December 31 of the relevant year) to a single $250,000 ($150,000 if any member of the group is a service organization in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting) amount in order to compute the accumulated earnings credit.¹ This amount must be divided equally among the members of the controlled group unless future regulations provide that unequal allocations are permissible.²

In addition to the graduated tax rate schedule outlined in Q 8955, a corporation will be subject to a penalty tax if, for the purpose of preventing the imposition of income tax upon its shareholders, it accumulates earnings instead of distributing them as dividends.³ The tax is 20 percent of the corporation’s accumulated taxable income (15 percent for tax years beginning prior to 2013).⁴

Planning Point: IRS officials have noted that additional guidance may be needed on the application of the accumulated earnings tax in the wake of tax reform. The 2017 tax reform legislation lowered the corporate tax rate from 35 percent to 21 percent, potentially providing motivation for some companies to convert to C corporation status rather than attempt to interpret the complicated pass-through provisions that apply post-reform. However, the legislation did not modify the accumulated earnings tax, which applies a 20 percent penalty tax to undistributed corporate earnings and profits in excess of the reasonable business needs of the company. This “reasonableness” standard can be difficult to interpret and could require additional guidance in the coming years, as more businesses may attempt to take advantage of lower corporate rates by simply distributing fewer dividends to business owners.

“Accumulated taxable income” is taxable income for the year (after certain adjustments) minus the federal income tax, dividends paid to stockholders (during the taxable year or within 2½ months after the close of the taxable year), and the “accumulated earnings credit.”⁵

A corporation is permitted to retain amounts required to meet the reasonable needs of the business—the tax will only be imposed upon amounts in excess of these amounts. To facilitate this permitted retention, an accumulated earnings credit is allowed. A corporation must demonstrate a specific, definite and feasible plan for the use of the accumulated funds in order to avoid the tax.⁶