The June 2018 Penn Wharton Budget Model survey indicated that over 235,000
business owners are projected to convert their pass-through businesses to C corporations.
Their primary motivation is to take
advantage of the new 21% corporate tax rate under the 2018 Tax Cuts and Jobs
Act. This is particularly important for
business owners who can’t fully benefit from the new Qualified Business Income
deduction. In fact, the biggest switchers are owners of specified service
businesses whose taxable income exceeds $415,000 for married filing jointly
Although the new 21% rate is tempting, C
corporations are subject to double taxation. Corporate income is taxed once at
the entity level and again when it is distributed to shareholders as dividends.
This can be avoided if the corporation retains all of it’s profits to finance
growth. However, this opens the door to
the Accumulated Earnings Tax (AET) if profits accumulate beyond the reasonable
needs of the business.
is a penalty tax imposed on corporations for unreasonably accumulating
earnings. The tax rate on accumulated earnings is 20%, the maximum rate at
which they would be taxed if distributed.
The tax is in addition to the regular corporate income tax and is
assessed by the IRS, typically during an IRS audit. There is no IRS form for
reporting the AET. If imposed, the earnings are subject to triple taxation when
eventually distributed to the shareholders. Once at the entity level, then when the AET
is imposed and finally when the accumulated earnings are distributed to
The AET applies when there is intent to avoid
income tax at the shareholder level by accumulating earnings in the
corporation. The AET applies even when tax avoidance is not the main reason for
the accumulation of income but is only one of several reasons. Keep in mind the IRS allows for an
accumulated earnings credit of $250.000 or $150,000 if you are taxed as a Personal
Service Corporation. Therefore, once your retained earnings exceed those limits
you need to be concerned about the AET and document why your corporation needs
accumulated earnings exceeding that amount.
The fact that a corporation is a holding or
investment company is automatically considered evidence of the existence of a
tax avoidance purpose unless the corporation can establish it wasn’t formed to
avoid tax. A holding company is
a corporation in which there is practically no activity other than the holding
of investment property. An investment
company is one that buys and sells stock, securities, real estate, and
other investment property, in addition to holding investment property. If the
corporation is not a holding or investment company, a tax avoidance motive is
considered present if the corporation has accumulated earnings and profits in
excess of the reasonable needs of the business unless it can prove otherwise by
a preponderance of the evidence. The IRS regulations identify the following
situations that may indicate accumulations beyond the reasonable needs of the
- Loans to
shareholders or related parties.
- Payments by the
corporation that personally benefit the shareholders.
- Investments in
assets having no reasonable relationship to the corporation’s business.
- A weak dividend
- Retention of
earnings to provide against unrealistic hazards.
- Working capital
levels that appear high in relation to the needs of the business.
7. Salaries paid to shareholder/employees that
are either extremely high (avoiding corporate
tax) or extremely low (avoiding shareholder income and employment tax).
The AET is not assessed if accumulated
earnings are reasonable in light of business needs. This subjective test can be
satisfied by a variety of business reasons including retaining earnings to
satisfy the reasonably anticipated future needs of the business. The IRS regulations provide some broad
criteria that can be used to justify that earnings are being accumulated for
reasonable business needs. These include:
- Providing for a
business expansion or plant replacement.
- Acquiring a
business enterprise through purchasing stock or assets.
the retirement of company debt created in connection with its trade or
necessary working capital for the business.
- Providing for
investments in suppliers, or loans to customers or suppliers to maintain the
business of the corporation.
6. Providing for contingencies such as the payment
of reasonably anticipated losses such as an
or potential lawsuit, loss of a major customer, or self-insurance.
The accumulated amount does not have to be
used immediately or within a short period after the close of the tax year, so
long as it will be used within a reasonable time depending on all the facts and
circumstances relating to the future needs of the business.
To avoid the AET which is 20% of "accumulated
taxable income", a corporation must be able to demonstrate to the IRS that its
accumulations are necessary to meet its business needs. The corporation must
have sufficient facts and documentation to substantiate that the plans for
present and future business needs require additional funds. A determination of
whether the accumulation of earnings and profits is a reasonable business need
is based on the facts and circumstances of each case.
The dramatic reduction in the corporate tax rate from 35% to 21%
has sparked renewed interest in the AET. Although it remains to be seen whether
flow-through entities will rush to covert to C corporations, those that do will
need to pay attention to this tax. Conversion
may be the way to go if owners have no need for distributions and the
corporation avoids the AET by proving its accumulations are for the reasonable
needs of the business.
If you have any questions, please call Gregory J. Spadea at