If you operate your business as a C corporation, you need to make sure the IRS won’t hit you with the 20 percentaccumulated earnings tax penalty, because that penalty is not tax-deductible, and on top of the 21 percent corporate rate (think 41 percent tax on those earnings).
How the C Corporation Taxes Work
One of the most significant changes brought about by the Tax Cuts and Jobs Act (TCJA) was establishing a single21 percent tax rate for C corporations—a reduction of 14 percentage points (54 percent) from the former topcorporate rate.
Unlike many TCJA changes, which are scheduled to sunset in 2025, the 21 percent corporate rate is permanent.
The 21 percent corporate rate is 16 percentage points lower than the 37 percent top personal income tax rate ineffect through 2025. It’s 18.6 percentage points lower than the 39.6 percent top personal rate scheduled to go intoeffect in 2026 unless the lower 37 percent rate is extended.
Indeed, the C corporation tax rate is lower than all but the two lowest personal tax brackets.
Where’s the bad news? Due to double taxation, much of the benefit of the low corporate rate can be lost whencorporate profits are distributed to shareholders as dividends, which are taxed at a 15 or 20 percent rate (23.8percent for higher-income shareholders subject to the net investment income tax).
For example, if a C corporation has $1,000 in profit, it must pay a $210 tax; if it then distributes the remaining $790to the shareholders, they likely pay at least a 15 percent tax on the dividend, or $119. The total tax paid is $329—almost a 33 percent total tax.
There is an easy way to avoid double taxation: retain the money in the business so it’s taxed only once.
Unfortunately, the IRS thought of this long ago. It can impose a 20 percent accumulated earnings tax (AET) on Ccorporations it claims are retaining profits to avoid double taxation.
So, if a corporation improperly retains $1,000,it would end up paying a 41 percent tax on that amount.
A C corporation does not assess the AET for itself and then voluntarily pay via its tax return. The AET is a penaltytax imposed only after an audit in which the IRS concludes that insufficient dividends were paid out compared withthe amount of income accumulated by the corporation.
Think of AET as a hidden tax. You never see a tax form looking for that money. You likely have not thought about it—or if you have, you have forgotten about it. And then, wham! The IRS does an audit, and you are exposed.
Large balances in retained earnings, cash, marketable securities, or loans to shareholders reported on acorporation’s balance sheet on Form 1120, Schedule L may result in AET exposure.
The AET can be imposed on any C corporation, including public corporations. However, small, closely held Ccorporations are the most likely targets for the IRS because their shareholders are more likely to influence dividendpolicy than those in public corporations.
In the past, the AET has not been a high-priority item for IRS auditors, but circumstantial evidence indicates thatthis could be changing.
Fortunately, there are many ways to avoid problems with the AET.
Elect S Corporation Status
You don’t have to worry about the AET if you have an S corporation, since this pass-through entity does not retainearnings that the government has not taxed in full. A C corporation can make the S corporation election within thefirst two and a half months of the tax year or at any time during the preceding year.
But if you elect S corporation status, it protects you from the AET only prospectively—your prior-year excess Ccorporation accumulations remain subject to audit assessment.
Retain No More than the Minimum AET Credit
All C corporations are permitted to retain a minimum amount of earnings without being subject to the AET.
For C corporations other than personal service corporations, the amount is $250,000, minus accumulated earningsat the close of the preceding year. The credit amount is $150,000 for C corporations whose principal function isperforming services in accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, or the performing arts.
If $250,000/$150,000 doesn’t seem like much money, that’s because the limits were established in 1981 and havenever been adjusted for inflation. If they were inflation adjusted, as of 2024 they would have to be$853,481/$512,089.
There are various ways a C corporation can reduce its retained earnings to stay within the $250,000/$150,000limits—for example:
Pay out dividends (this also helps show lack of intent by the corporation to avoid income tax on itsshareholders by accumulating earnings and profits instead of distributing them).
Increase salaries and bonuses for corporate employees (but employee compensation must bereasonable or it could be recharacterized as a disguised dividend by the IRS.
Provide more employee fringe benefits, such as a qualified pension plan.
The minimum AET credit benefits new corporations the most, since they have no accumulated earnings from theprior year.
Establish That Retained Earnings Are for Reasonable Business Needs
Obviously, many businesses need to accumulate more than $250,000/$150,000 in order to function. Fortunately,corporations can accumulate earnings beyond $250,000/$150,000 if it is essential to the “reasonable needs of thebusiness.”
There is no maximum limit on the amount of earnings a corporation can accumulate, so long as the amount isreasonable.
Whether a corporation’s earnings are being accumulated for reasonable business needs is a highly subjective andfact-specific judgment. Many factors can be considered. IRS regulations list the following non-exclusive criteria thatindicate the earnings and profits are being accumulated for the reasonable needs of the business:
Providing for bona fide business expansion or plant replacement
Acquiring another business by purchasing its stock or assets
- Allowing retirement of company debt
Providing necessary working capital for the business—a corporation should have sufficient liquidassets on hand to pay all of its current liabilities and any reasonably anticipated extraordinaryexpenses, plus enough to operate the business during one operating cycle
Providing for investments in or loans to customers or suppliers if necessary to maintain thecorporation’s business
Providing for contingencies such as payment of reasonably anticipated product liability losses, actualor potential lawsuits, loss of a major customer, or self-insurance
The Internal Revenue Manual lists even more bona fide business reasons for corporations to retain earnings:
Redemption of stock held by minority stockholders
Need to meet competition
Need to finance pension or profit-sharing plans for the employer
On the other hand, the absence of a bona fide business reason for accumulating earnings is shown by theseactivities:
Loans to shareholders, or corporate-level expenditures for the personal benefit of shareholders
Loans having no reasonable relation to the business, made to relatives or friends of shareholders orothers
Loans to brother-sister corporations
Investment in properties or securities that are unrelated to the activities of the business
Retention of earnings to provide against unrealistic hazards
The reasonable needs of a business include its future needs as well as its present needs. The corporation must beable to show it has specific, definite, and feasible plans to use its accumulated earnings to meet future needs.
To avoid the AET, you need to document a plausible business explanation for your corporation’s accumulation ofearnings. This should be done in corporate minutes, board resolutions, business plans, or budget documents, orwith other contemporaneous documentation.
For example, if funds are set aside to purchase a new building, the corporation’s budgeting documents and anyinternal communications (including emails) concerning the new building should be retained to show the reasonswhy the company set aside the earnings.
The key word here is “contemporaneous.” Corporate minutes or other documentation of the reasons for anaccumulation prepared long after the fact are usually treated as self-serving.
Takeaways
Here are five takeaways from this article:
The IRS can impose the 20 percent AET on C corporations that retain too much in earnings to avoidissuing taxable dividends to shareholders. The tax is a penalty tax imposed upon audit; corporationsdo not assess the tax on themselves.
Large balances in retained earnings, cash, marketable securities, or loans to shareholders reportedon a corporation’s balance sheet on Form 1120, Schedule L may disclose AET exposure.
C corporations are permitted to retain up to $250,000 in retaining earnings without being subject tothe AET. The amount is reduced to $150,000 for C corporations whose principal function isperforming services in accounting, actuarial science, architecture, consulting, engineering, health,law, or the performing arts.
Corporations may accumulate earnings beyond $250,000/$150,000 if the accumulation is essentialto the “reasonable needs of the business”—for example, to provide necessary working capital, fundexpansion needs, or pay debts.
To avoid the AET, C corporations should document the reasons for accumulating earnings beyond$250,000/$150,00 in corporate minutes, board resolutions, business plans, or budget documents, orwith other contemporaneous documentation.
