Reducing AE tax.

• Author: Ellentuck, Albert B.
• Position: Accumulated earnings

The accumulated earnings (AE) tax is a penalty imposed by Sec. 531 on corporations for accumulating earnings to avoid income tax at the shareholder level. However, the tax is not assessed if earnings are not accumulated beyond the business's reasonable needs.

Regs. Sec. 1.537-1(b)(2) states that the reasonableness of anticipated needs is judged on the facts existing at the close of the tax year. This means that subsequent events cannot be used to show that the retention of earnings and profits (E&P) was unreasonable at the close of the tax year, if all the elements of reasonable anticipation are present at that time. For example, an accumulation was not unreasonable when expansion plans were abandoned after a manager/shareholder's illnes; see Sterling Distributors, Inc., 313 F2d 803 (5th Cir. 1963). However, subsequent events may determine whether a taxpayer actually intended to consummate (or has actually consummated) the plans for which it accumulated the E&P. In this regard, projected expansion or investment plans should be viewed in light of the facts during each year and at the close of the year. If a corporation has justified an accumulation for future needs by plans never consummated, it must take this into account in determining whether subsequent accumulations are reasonable.

When to Determine Reasonable Needs

Lobo Grading, Inc. is a C corporation site contractor that uses motor graders and bulldozers to accomplish the majority of its work. Lobo's revenues have averaged $4.5 million for the past four years; it owns over $1.5 million in equipment.

Due to restrictions, Lobo has been able to finance only about 70% of the equipment's value. However, in January 2004, it found a lender to finance 100% of all equipment purchases and refinance all existing equipment loans.

Although in the past, Lobo clearly has needed up to $450,000 in accumulated earnings ($1,500,000 x 30%) to afford the equipment necessary to produce revenue, the change in lending policies eliminated that need for capital as a valid reason for accumulating income. Thus, in 2004 and later years, the IRS could impose the AE tax.

Documentation

To avoid an IRS attack, a corporation should identify and quantify its anticipated needs and then thoroughly document them. If the IRS challenges the taxpayer's position on the AE tax, it will do so severn years later. Thus, the IRS will be able to determine whether the corporation followed through with its plans. It will also be able...