The accumulated earnings tax is a tax imposed by the federal government on companies with retained earnings deemed to be unreasonable and in excess of what is considered ordinary. Essentially, this tax encourages companies to issue dividends, rather than retain their earnings.

Breaking Down Accumulated Earnings Tax

C corporations that have a habit of accumulating their earnings or profits, instead of distributing them as dividends to shareholders will be subject to the accumulated earnings tax if the amount of earnings retained is above a certain level. These companies may accumulate earnings up to $250,000 without incurring an accumulated earnings tax; any amount higher is deemed by the Internal Revenue Service as beyond the reasonable needs of the business. A business whose principal function is performing services in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and the performing arts has an exemption amount of $150,000.

In effect, an accumulated earnings tax of 20% is applied on retained earnings that exceed the exemption amount. The government imposed this tax to deter investors from negatively influencing a company's decision to pay dividends since investors or shareholders would avoid paying tax on dividends if the company does not distribute the earnings in the first place. The premise behind this tax is that companies that retain earnings typically experience higher stock price appreciation. Although this is beneficial to stockholders as capital gains taxes are lower than dividend taxes, it is detrimental to the government because tax revenues decrease. By adding an extra tax upon a firm's retained earnings, the taxman will either collect more taxes from the company or persuade them to issue dividends, thereby, allowing the government to collect from the stockholders.

A corporation that has an unreasonable accumulation of earnings may be liable to pay the accumulated earnings tax unless the business can show that the earnings were not accumulated to allow its shareholders to avoid tax. In other words, the firm has to show that the retained earnings are over the threshold for reasonable needs of the business, which the IRS defines as:

  • Specific, definite, and feasible plans for the use of the earnings accumulation in the business.
  • The amount necessary to redeem the corporation's stock included in a deceased shareholder's gross estate if the amount does not exceed the reasonably anticipated total estate and inheritance taxes and funeral and administration expenses incurred by the shareholder's estate.

S corporations are not liable for the accumulated earnings tax since earnings in these firms are taxed to investors and shareholders whether the company makes distributions to them or not.