You may want to leave money in your C-corporation to avoid personal taxes. The accumulated earnings tax limits the effectiveness of that strategy.
Accumulated Earnings Tax: A Limit on Using C-Corporations to Avoid Personal Taxes
If you want to keep your personal taxable income down, you may have considered using a C-corporation. While a C-corporation has double taxation, you generally only pay personal taxes when you take a salary or dividends.
C-corporations are in contrast to pass-through entities like S-Corporations where the annual profits get taxed on your personal tax return each year.
The catch to leaving money in a C-corporation is the accumulated earnings tax.
If you have accumulated earnings beyond the reasonable needs of the business, your C-corporation will have to pay the accumulated earnings tax. You’ll still pay personal taxes when you take money out of your corporation.
What is the accumulated earnings tax?
The accumulated earnings tax is an extra 20% tax on excess accumulated earnings. It’s in addition to your corporate income taxes for the year, and it doesn’t reduce your future personal taxes.
For example, if the IRS determines your corporation has an extra $1,000,000 in cash beyond the reasonable needs of the business, you could face an additional tax of $200,000.
The purpose of the accumulated earnings tax is to prevent people from leaving accumulated earnings and profits inside of a corporation to avoid paying personal taxes on dividends.
The accumulated earnings tax used to be at the highest individual income tax rate which is currently 37% and used to be 39.6%. Subsequent tax law changes reduced the accumulated earnings tax to 15% before raising it to 20%.
When does the accumulated earnings tax apply?
The accumulated earnings tax applies when the IRS determines that a C-corporation is holding excess earnings and profits to avoid shareholder income tax.
The Internal Revenue Service considers three primary factors:
- The C-corporation not paying dividends while unreasonably accumulating earnings
- The C-corporation investing accumulated earnings in investments not related to the business
- The C-corporation paying personal expenses for shareholders or lending shareholders money
There is typically a $250,000 accumulated earnings credit before the accumulated earnings tax kicks in. So if you have $300,000 in accumulated earnings, the tax would likely only apply to $50,000 or less.
What is unreasonable accumulation of earnings?
Unreasonable accumulation of earnings is when you have accumulated earnings beyond the reasonable needs of the business. The IRS considers things like:
- Whether your cash reserves are reasonable compared to your ongoing expenses and other factors
- Upcoming maintenance or other capital expenditures that you’re planning for
- Your business’s plans for growth and whether you have taken advantage of previous opportunities to grow
In short, when you build up your retained earnings, you should be able to demonstrate a reasonably anticipated business need for doing so. If your reason for holding accumulated earnings is to avoid personal taxable income, you’ll likely owe the accumulated earnings tax.
How do you define unreasonable?
What’s reasonable versus unreasonable is a subjective standard. Again, the IRS is mainly trying to determine your intent.
One guideline (but not an absolute rule) is whether your financial ratios are similar to similar businesses. For example, if businesses in your industry usually maintain cash reserves equal to 10% of annual expenses, the IRS will probably have questions if you’re at 200%.
Of course, you may have business reasons for not matching guidelines. You may have identified a weakness in how competitors are run or you may be preparing for an expansion. You can maintain additional accumulated earnings if the purpose is to meet the reasonable needs of the business.
In most cases, you’ll probably want to talk to a tax accountant to make sure you’re following the IRS rules and have good documentation of how your retained earnings support the reasonable needs of your business.
Does an LLC pay accumulated earnings tax?
The IRS doesn’t recognize LLCs for tax purposes. It depends on how you’ve elected to have your LLC taxed.
If you’ve elected to have your LLC taxed as a C-corporation, you could have to pay accumulated earnings tax. If you chose to be taxed another way, accumulated earnings tax probably won’t apply.
Why can giant corporations like Apple hoard billions of dollars in retained earnings?
You may be wondering why the accumulated earnings tax seems to only target small corporations when giant companies like Apple can hoard billions of dollars in cash. There are generally two reasons for this.
First, it’s much harder for a publicly traded corporation to be considered to be helping shareholders to avoid income tax. With millions of shareholders with different tax goals, it’s simply not the same as an individual wanting to use a single-owner C-corporation as a tax avoidance tool.
Second, large corporations frequently make acquisitions of other companies worth millions of dollars alone. Since opportunities are infrequent, it’s easy for them to justify holding cash as within the reasonable needs of the business.
Legitimate Ways to Defer Income
If you were looking at using accumulated earnings to defer personal income to lower your personal tax liability, there are other potential strategies you may want to consider.
- Keeping your accumulated earnings below the minimum amount to owe accumulated earnings tax
- Using a C-corporation but actually investing in growth either for a future sale or higher dividends at the end of the growth stage
- Using a pass-through entity and maximizing your contributions to a SEP IRA or Solo 401(k)
- Look into other planning tools such as a charitable gift annuity