The federal government discourages companies from “stockpiling” their capital by using the accumulated earnings tax. This tax—added as a penalty to a company’s income tax liability—specifically applies to the company’s taxable income, less the deduction for dividends paid and a standard accumulated tax credit of $250,000 ($150,000 for personal service corporations). In other words, the surest way to stay clear of the tax on accumulated taxable income is to maintain a company account balance below the level of those standard credits.
The tax rate on accumulated taxable income currently stands at 20%, and fortunately the American Taxpayer Relief Act (ATRA) kept it from rising to a much higher scheduled rate of 39.6%. Additionally, the IRS will forgo the tax penalty on accumulated income if the company provides a statement and plan showing that the capital accumulation is being done for a “reasonable business need” within the tax year in question. Some examples of these needs include retirement of debt, accumulation of working capital– purchase inventory, business expansion, acquisition of another business, or to help get rid of business debt (loans to shareholders, friends or relatives generally don’t qualify).
Not every business or industry is equal, of course, and some companies will have greater justification for accumulating assets in a fiscal year than will others. If you believe that your own company may have a case to be forgiven the accumulated earnings penalty, start keeping detailed records of the situations that help bolster that case.
- Pay out dividends consistently and have a written policy drafted for your company that lays out the system. Dividends are also a strategy to employ if you’re very close to being under the standard tax credit—simply pay out extra dividends to get the accumulated earnings beneath the $250K level.
- Have your replacement, maintenance, and safety costs assessed by an expert and their reports added to your files.
- If you intend to expand the business, proceed to the “blueprint” stage at your earliest opportunity.
- Corporate minutes should include records of business reasons justifying the accumulated earnings.
Talk to your accountant if you have accumulated earnings or anticipate earning above the allotted amounts in order to take the proper steps of documentation to strengthen your case and avoid this tax.