Defending the accumulated earnings tax case.

• Author: Ball, John S.

This article explores planning opportunities and defense strategies for corporations potentially exposed to the accumulated earnings tax.

The penalty tax for the unreasonable accumulation of corporate earnings has formed a part of the Tax Code for many years, and is viewed as a necessary component of the federal system which taxes corporate earnings both to the entity and then again to the owners once they are distributed. The [sections] 531 penalty tax is designed to prevent corporations from unreasonably retaining after tax liquid funds in lieu of paying current dividends to shareholders, where they would be again taxed as ordinary income at shareholder tax rates. The accumulated earnings tax equals 39.6 percent of "accumulated taxable income" and is in addition to the regular corporate tax.[1] Accumulated taxable income is taxable income modified by adjustments in [sections] 535(b), and as reduced by the dividends paid deduction under [sections] 561 and the accumulated earnings tax credit under [sections] 535(c).[2]

Although the top individual tax rates are approximately the same as the combined federal and Florida corporate tax rates, an individual bent on avoiding taxes arguably could use the corporate form to unreasonably accumulate after-tax corporate earnings, and later hope to bail out those earnings at capital gains rates on sale of the company. Alternatively, the shareholder may intend to retain the shares for the date of death basis step-up.[3] Long term capital gains of individuals are now generally taxed at a maximum of 20 percent, rather than at the 39.6 percent top marginal rate on ordinary income. Consequently, as with the personal holding company tax, the accumulated earnings tax penalizes a corporation for failing to distribute earnings which are not needed for legitimate business purposes. Because the accumulated earnings tax is a penalty, it is, therefore, strictly construed.[4]

All private and public subchapter "C" corporations, with limited exceptions, are potentially subject to the accumulated earnings tax.[5] Although publicly held corporations can be found to have liability for accumulated earnings tax,[6] closely held corporations are the most likely targets of this assessment since their shareholders often are perceived to be in a better position to influence dividend policy. Corporations with a high degree of liquidity are vulnerable. The tax is levied on corporations "formed or availed of" for the purpose of avoiding income taxation of shareholders by accumulating, instead of distributing, its earnings. The penalty tax thus requires the intent to avoid tax at the shareholder level. The accumulation of earnings beyond the reasonable business needs of a corporation is determinative of intent to avoid shareholder taxes, unless disproved by a preponderance of the evidence.[7] A corporation which has accumulated its earnings beyond its reasonable needs may still rebut the presumption of intent. However, in practice it is the unusual case indeed in which a closely held corporation with excess earnings and profits will be able to prove the lack of tax avoidance motive.[8] The corporation must prove, by a preponderance of the evidence, that avoidance of shareholder taxes was not one of the purposes motivating its accumulation policies.[9] The reasonable needs of the business not only are critical in determining whether the proscribed intent exists, but these needs also establish a credit amount which reduces accumulated taxable income in defining the tax base against which the penalty tax is applied.[10]

The critical inquiry in every accumulated earnings tax case, therefore, is whether the retention of earnings can be justified by the reasonable needs of the business. The reasonable business needs of a corporation include not only its current needs, but also its "reasonably anticipated" future business needs as well. Under the standard of the Treasury Regulations, the needs of the business are determined at the close of the taxable year in issue.[11] This is the point at which management presumably decides how much cash is needed for normal business operations, and for future adverse risks and contingencies. The excess not so needed, the theory goes, should then be distributed to the shareholders as dividends, to be taxed as ordinary income.

This article will review the difficulty in proving "reasonable business needs" on audit and at trial, and also will explore business needs often overlooked in the analysis of the working capital requirements of a corporation faced with the prospect of having to justify its retained earnings on audit.

Objective Factors of Intent

The applicable Treasury Regulations list specific factors which, if established, tend to indicate the presence of a motive to unreasonably accumulate earnings. The presence of such factors sometimes distracts the court from the central issue in the case. The core issue is always whether the corporation's business needs exceed its available funds. For example, a shareholder loan is one such indicator of intent. The reason is apparent. Why would a corporation, which argues that it needed the cash reserves for its business, have made a loan to its shareholders or to a related party? When such a loan is made, it then must be explained and justified in a business context. The Treasury Regulations focus upon the potential abuse of the corporate form for the personal benefit of the shareholders, in listing the following nonexclusive factors which evidence the proscribed intent:[12]

1) Dealings between the corporation and its shareholders for the personal benefit of the shareholders, such as personal loans, or the expenditure of funds by the corporation for the personal benefit of the shareholders;

2) The investment of earnings in businesses or assets having no connection with the business of the corporation; and

3) A poor corporate dividend record. Such factors, and other similar factors, are listed elsewhere in the regulations as also indicating generally that the retention of earnings and profits is not for business purposes, and may be excessive.[13] Nevertheless, the indicia of unreasonable accumulations can be overcome with a proper foundation to show the reasonable needs of the business are indeed in excess of available corporate funds.[14] Thus, if a corporation has invested in an asset which is neither liquid nor related to its business, such as an investment in raw land held for speculation, the corporation still may attempt to show that its business needs would still be unfunded even assuming the investment had never been made. The negative inference, however, is obvious and difficult to overcome. It is important to note that...