Accumulated Earnings Tax
A fine imposed onto public corporations who accumulate or retain earnings beyond the reasonable threshold.
Accumulated Earnings Tax Details
Internal Revenue Service (IRS) sets the accumulated earnings tax scheme to prevent companies from excessively accumulating their income and to pay dividends instead. The reason why the IRS discourages retaining earnings is, often, companies who do so are influenced by their shareholders, or more specifically, their board of directors. By keeping a company from paying dividends, shareholders are essentially able to avoid having to pay income from dividends tax.
To stay profitable, shareholders will instead rely on capital gains, the growth in value of investments, which incurs less tax when realized/sold. Typical C corporations — where shareholders are taxed separately from the company — may retain up to $250,000 of their earnings before incurring accumulated earnings tax. For personal service companies, who deal in health, law, consulting, accounting, or other service-based fields, the threshold is $150,000.
If the amount of retained earnings is higher than the threshold, the IRS imposes 20% of that amount as accumulated earnings tax. That said, even if retained earnings go beyond the threshold, any of the companies above may avoid accumulated earnings tax if they meet certain conditions.
To be exempt from accumulated earnings tax, these companies need to show to the IRS that they retain their earnings for the reasonable needs of the business. If they can do so, they no longer have the obligation to pay the tax, regardless of the retained earnings amount. The IRS defines some of the criteria that meet the “reasonable needs” condition:
- Specific, definite, and feasible plans of usage for the accumulated earnings.
- The company plans to use accumulated earnings as a measure to anticipate product liability losses.
- Redemption needs in certain situations. For instance, if a shareholder died during the current taxable year, the company can use accumulated earnings to redeem stock in the gross estate of the shareholder.
Example of Accumulated Earnings Tax
Company A is a C corporation that deals in selling beverages and is required to pay accumulated earnings tax if it retains more than $250,000 of its earnings. In the previous period, company A has a retained earnings amount of $150,000. During this period, it is able to produce a net income of $200,000. To avoid having to pay for accumulated earnings tax, Company A has to distribute at least $100,000 of net income as dividends:
$150,000 + $200,000 - $100,000 = $250,000
If Company A wishes to retain all of its earnings, for example, to buy new equipment, it can do so without incurring tax. The company can do this since it has a specific and feasible plan of usage for the accumulated earnings. As long as such a decision is not for shareholders’ taxation benefit, the company can provide proof to the IRS that retaining otherwise excessive earnings is necessary.
Significance of Accumulated Earnings Tax
It may seem weird that there are times when shareholders wish to prevent dividend payments since they would normally choose otherwise. Although, keep in mind that, for shareholders, dividends are not the only way to gain profits. Companies that retain excessive earnings will most likely have their stock price goes up.
If the stock price appreciates, shareholders will be able to gain higher profit from selling stock shares, in other words, realizing capital gains, which incurs lower tax expense. The government isn’t fond of this as the practice will decrease tax revenues.
By imposing additional tax expense for excessive accumulated income, the government can either collect more taxes from the company or urge the company to distribute dividends, which will incur income from dividends tax for shareholders. In a different circumstance, the accumulated earnings tax is also beneficial for investors who are looking for short-term gain through dividends.
Accumulated Earnings Tax vs. Income Tax
Accumulated earnings tax and income tax differ in the stage where they are imposed. For corporations, the IRS imposes income tax from earnings before tax (EBT), which is gross income minus all operating and capital expenses including interests. Afterward, the firm pays the imposed taxes and EBT becomes net income or the bottom line, the leftover earnings after all of the expenses including taxes are taken into account.
Once the figure of net income is out, a company may choose to either retain its earnings and/or distribute a certain percentage of it. If the company chooses to retain its earnings but the amount exceeds the threshold set by the IRS, the IRS has the ability to impose an additional tax on the company, known as accumulated earnings tax. However, if the company has a reasonable need to accumulate or retain earnings, it doesn’t have to pay the extra tax.