The accumulated earnings tax: a practical approach to a subjective assessment.

• Author: Goldberg, Michael J.

The accumulated earnings tax (AET) is essentially a penalty imposed on corporations that accumulate earnings rather than pay them out as dividends. Historically, there were two reasons for the AET. First, the AET was intended as a mechanism to enforce the principle that corporate earnings were subject to double taxation - at the corporate level, and then at the shareholder level when distributed. Second, until the 1980s, the tax rate applicable to investment income of corporations was significantly lower than that of individuals. The AET provisions (Secs. 531-537), as well as the personal holding company tax provisions (Secs. 541-547), were intended to discourage generating investment income through a corporation.

This article will discuss the AET provisions with a view to what practical approaches to take when there is a substantial accumulation of income or when the issue is raised by the IRS. The AET issue, while not common, is an extremely important one in certain cases, since the amount of the assessment can easily become very large and, if it is assessed in one year, it is likely to be considered for assessment in earlier and later years.

Computation of Tax

Under Sec. 531, a 28 % tax is imposed on "accumulated taxable income," as defined in Sec. 535. Sec. 532(a) contains a "prohibited purpose" element, which provides that the AET will apply to a corporation "formed or availed of for the purpose of avoiding the income tax with respect to its shareholders or the shareholders of any other corporation, by permitting earnings and profits [E&P] to accumulate instead of being divided or distributed." The tax avoidance purpose need not be the only purpose for accumulating earnings - if it is only one of the purposes, the AET can be applicable. Sec. 532 states, in essence, that the AET applies to every corporation, except for personal holding companies, foreign personal holding companies, exempt organizations and passive foreign investment companies. S corporations are not subject to the AET by virtue of Sec. 1363(a), which states that, with exceptions not relevant here, S corporations are not subject to corporate Federal income tax. Foreign corporations are subject to the AET if their direct or indirect shareholders are subject to income tax because they are U.S. citizens or residents or nonresident aliens subject to Sec. 871.(1)

Under Sec. 533(a), an accumulation of earnings beyond the reasonable needs of the business is determinative of the prohibitive purpose of Sec. 532(a), "unless the corporation by the preponderance of the evidence shall prove to the contrary. "The fact that a corporation is a mere holding or investment company is prima facie evidence of the prohibitive purpose.(2) Dealings between the corporation and its shareholders, such as loans and withdrawals, corporate investments unrelated to its business, and the lack of a dividend history are factors in considering the existence of the prohibitive purpose.(3) Sec. 533 and the regulations there-under begin to get into the question of the burden of proof in AET cases, but it is Sec. 534 that fully addresses this issue. Since the imposition of the AET is, to a large degree, subjective, this issue is very important, and will be reviewed later.

Accumulated taxable income (ATI) is defined in Sec. 535(a) as taxable income as adjusted under Sec. 535(b), minus the sum of the dividends-paid deduction (as defined in Sec. 561) and the accumulated earnings credit (as defined in Sec. 535(c)). Thus, as a general rule, if a company has accumulated substantial earnings, but has a taxable loss (and no ATI) in the current year, there should be no current year AET exposure. The adjustments in Sec. 535(b) are intended to convert taxable income into "economic" income, i.e., what is actually available for distribution. Thus, for example, Federal income taxes and capital losses are deductible; charitable contributions are allowable without regard to the 10% limit; but net operating loss and dividends received deductions are not allowed. However, not all "economic" expenditures are deductible in computing ATI, e.g., suspended passive activity losses and penalties. Curiously, tax-exempt income is not taken into account in determining ATI.(4) In addition, capital gains are a deduction in arriving at ATI. To prevent double-counting, the capital gain deduction is reduced by the income tax attributable to the capital gain. For companies...