C Corporation? Beware of the Hidden Tax


You’re pleased with the 21 percent corporate tax rate.

And you know that having your corporation pay you dividends with its after-tax profits subjects those profits to double taxation.  But you’re happy that the dividend receives tax-favored capital gain treatment.  Okay, tax one at the corporate level and tax two at the personal level, not so bad.  But here’s a tax to make you mad. You may know of it and not think about it. Or you may not even know about it.  This tax, known as the accumulated earnings tax, is a penalty tax on the corporation that does well but doesn’t share its profits in a manner agreeable with the IRS.

The accumulated earnings tax is a 20 percent corporate-level penalty tax assessed by the IRS, as opposed to the tax paid voluntarily when you file your corporate tax return.  To trigger the tax, you need to suffer an IRS audit that notes your failure to pay dividends when the corporation’s accumulated earnings exceed $250,000, or $150,000 for a personal service corporation, and the corporation cannot demonstrate an economic need for the “excess” accumulation of earnings.

Lawmakers enacted the $250,000 threshold in 1981, effective January 1, 1982.  That was 40 years ago, and it has not been increased for inflation.  If you apply the consumer price index inflation calculator to that $250,000, your result is $774,910.  But you don’t get to do that. Instead, you can face the 20 percent accumulated earnings tax if your accumulated earnings exceed $250,000 or a measly $150,000 if you are a personal service corporation.
The 20 percent penalty tax targets small corporations, although it applies to all corporations, including publicly traded corporations.

Here’s the question: Why do you need more than $250,000 in accumulated earnings?  If you can answer this question to the satisfaction of the IRS, you have no problem.  But don’t wait for the audit and the question. Be proactive. Get your reasons and dollar amounts into the corporate minutes. Here are some prompts to get you started on why you need to keep the earnings in the corporation: You need the money to pay a deceased shareholder’s death taxes, funeral, and administrative expenses under IRC Section 303. After all, shareholders do die.  You need the money to shut down, sell, and otherwise deal with corporate needs caused by the owner’s death. Let’s move away from death. The IRS in Reg. Section 1.537-2 gives you a nice list of reasons for accumulating C corporation earnings, as follows: Provide for bona fide expansion of business or replacement of plant  Acquire a business  Retire indebtedness of the corporation  Provide for investments in or loans to suppliers or customers if necessary to maintain the business of the corporation  Provide for reasonably anticipated product liability losses  From this same regulation, the IRS lists the following as likely unreasonable reasons for accumulating the earnings:  Making loans to the shareholders
Making loans to other corporations and business entities owned by the shareholders  Investing in properties unrelated to the corporation’s activities  Investing in securities unrelated to the corporation’s activities  Citing needs for unrealistic contingencies and hazards.

The 21 percent corporate tax rate may entice you to keep more money in your C corporation.  If your corporation’s accumulated earnings exceed $250,000, you should create a document that proves why you need the money inside the
corporation rather than paying it out as dividends.  If you suffer the 20 percent accumulated earnings penalty tax, you paid an unnecessary tax—and suffered a triple tax:
Tax on corporate income
Tax on excess accumulated earnings
Tax on dividend income[/vc_column_text][us_image image=”3643″][/vc_column][/vc_row]