Accumulated tax earning is a form of encouragement by the government to give out dividends, rather than keeping their earnings. It is a form of tax imposed by the Federal Government on firms and cooperation with retained earnings. This earning is considered unreasonable and somewhat unnecessary.
There is a certain level in which the number of earnings of C corporations can get. When the revenues or profits are above this level, the firm will be subjected to accumulated earnings tax if they do not distribute the dividends to shareholders. The threshold is $25000 without accumulated earning tax. According to the IRS, anything above this considered beyond the reasonable needs of the business.
There are, however, some classes of business with an exceptional amount of $150,000. Businesses with primary services in the field of accounting, architecture, health, engineering, performing arts, and law are in this category.
The business gets levied 20% as accumulated tax. This amount is applied to retained earnings above the retention amount. One of the reasons for this tax is to discourage investors from supporting the decision of a firm not to pay dividends since shareholders could stay away from paying tax on dividends if they do not get the earnings from the firm. The assumption behind coming up with this tax is that firms that retain earnings will have a higher stock price appreciation. At the same time, the share and stockholders benefit in terms of reduced capital gain tax, tax revenue decreases, which does not pay the government.
With this, the accumulated earnings tax intends to achieve either of two things: either the company pays more tax, or they issue dividends. With dividends, the government collects taxes from shareholders.
A firm with excess accumulation of earnings will be subjected to the accumulated earnings tax. If it can, however, prove that the reasons behind the earnings was not to help shareholders avoid tax, it might escape the accumulated earning tax. The implication of this is that the firm must be able to show that the needs of the business warranted the retained earnings. And according to the IRS, the needs must be definite, specific, and feasible.
Accumulated earnings tax does not apply to S corporations. This is because the earnings of these firms are taxed to shareholders and investors, not minding if the company makes distribution on them or not.
The federal government does not like the idea of firms using accumulated earnings tax to pile up capital. As a result, this tax comes as a penalty to the company, which applies to the taxable income of the company.
One of the most effective ways to avoid taxes on accumulated income is to have your firm's account balance below the given threshold.
Even though the tax rate on accumulated taxable income is 20%, it would have risen to 39.6% thanks to the intervention of the American Taxpayer Relief Act (ATRA) that prevented it from rising to such a higher rate.
As indicated above, if the capital accumulation is done for "reasonable business needs," the IRS might not issue the penalty. Classes of reasonable business needs are business expansion, accumulation of working capital, the retirement of debts, getting rid of business debts, absorbing another business. Bear in mind, however, that loans to friends, relatives, and shareholders do not qualify.
It should be noted that business differs. As a result, there could be a justifiable reason for some businesses to accumulate capital in a year compared to other businesses. If you think the reason your firm is accumulating the capital warrants forgiveness, be sure to have detailed records with which you can back up your case.
Be sure your dividends are paid out regularly and use a written policy draft. If you think you might be facing the standard tax credit soon, you can try and pay out the significant dividends. Besides, paying our extra dividends might also get your accumulated earnings below the $250,000 benchmark.
