FAQs About the Accumulated Earnings Tax
The flat 21% corporate federal income tax rate ushered in by the Tax Cuts and Jobs Act makes operating your business as a C corporation attractive. That rate applies to all C corporations, including those classified as personal service corporations (PSCs). When you compare the 21% corporate rate to the 37% maximum federal income tax rate for individual taxpayers, it's easy to see why C corporation status may seem alluring.
C corporations face tax issues that don't affect sole proprietorships, single-member limited liability companies (SMLLCs) treated as sole proprietorships for tax purposes and pass-through entities (partnerships, multimember LLCs treated as partnerships for tax purposes, and S corporations).
Here are some frequently asked questions about the accumulated earnings tax (AET), a potential drawback of operating a business as a C corporation.
Can My C Corporation Avoid Double Taxation by Simply Not Paying Out Dividends?
If not for the AET, the answer would be "Yes." If your C corporation business is successful, the company can build up a hefty amount of earnings and profits (E&P). E&P is a tax accounting concept similar to the financial accounting concept of retained earnings. While significant E&P indicates a financially healthy operation, it also creates tax concerns when getting money from the company. That's because, to the extent of a corporation's E&P, corporate distributions paid to shareholders will constitute taxable dividends.
This treatment results in double taxation of corporate earnings: once at the corporate level and again at the shareholder level when profits are distributed as taxable dividends. So, trying to avoid the double taxation problem by not paying dividends may not work. When your C corporation retains significant earnings rather than paying them out as double-taxed dividends, there's a risk that the company will get hit with AET.
How Does the AET Work?
AET is a corporate-level tax assessed by the IRS instead of a tax paid voluntarily with your company's federal income tax return. The IRS can determine the AET when:
A corporation's accumulated earnings exceed $250,000 ($150,000 for a PSC), and
The corporation can't demonstrate an economic need for the "excess" accumulated earnings.
In essence, the AET is a penalty tax on C corporations that retain "too much" of their earnings. The AET is effectively a backdoor way to achieve double taxation.
What's the AET Rate?
When the AET is assessed, the rate is the same as the maximum federal rate on individual taxpayers' dividends. Currently, that rate is 20%.
Important: While the current AET rate is only 20% of excess accumulated earnings, it could be higher if dividends are once again taxed at higher ordinary income rates as they previously were. However, the AET rate will likely remain at 20% until at least after the 2028 general election.
How Can My Company Demonstrate Reasonable Business Needs?
Perhaps the easiest way to avoid or minimize exposure to the AET is to show that your corporation doesn't have accumulated earnings over the AET threshold. For this purpose, you can reduce your corporation's accumulated earnings for funds the company reasonably needs to retain.
Your company may need these earnings to pay for business expansion, acquisition of a business, debt retirement, and working capital. Your tax advisor can help quantify your corporation's reasonable business needs for funds over the AET threshold.
Should My Company Bite the Bullet and Pay Dividends?
That might not be a bad idea. The current federal income tax rate on dividends received by individuals can't exceed 23.8%: the 20% maximum rate plus another 3.8% for the net investment income tax (NIIT). However, if applicable, most individuals won't pay more than 18.8% on dividends: 15% plus 3.8% for the NIIT. By historical standards, these are low rates.
An advantage of paying out dividends while tax rates are relatively low is that the dividends reduce your corporation's accumulated earnings balance. So, paying out dividends can reduce or eliminate your corporation's exposure to the AET in future years when the rate could be higher.
Should My Company Do a Stock Redemption?
Stock redemptions also may help avoid or minimize the AET. The general rule is that cash payments by a corporation to redeem (buy back) its shares are treated as corporate distributions to the recipient shareholder. As such, the payments are treated as taxable dividends to the extent of the corporation's E&P. Once E&P has been exhausted, any remaining redemption payments reduce the recipient shareholder's tax basis in the redeemed shares. Once the basis has been exhausted, any remaining redemption payments constitute capital gain for the shareholder.
The bottom line is that individual C corporation shareholders will receive historically favorable federal income tax treatment for stock redemption payments while the current tax regime is in place. This is true even if the payments are treated as taxable dividends.
In addition, stock redemption payments treated as taxable dividends will reduce your corporation's accumulated earnings balance. That will have the beneficial side effect of reducing or eliminating your corporation's exposure to the AET in future years when the rate could be higher.
How Does the AET Differ from the PHC Tax?
The personal holding company (PHC) tax can affect closely held C corporations that earn much income from dividends, interest, certain royalties, certain rents, personal service contracts, and estates and trusts. The tax is intended to target C corporations that are primarily used as individual investment ownership vehicles. It's imposed at 20% on undistributed personal holding company income. The PHC tax can be reduced or avoided by paying dividends.
If the PHC tax applies, the affected corporation must self-assess it by filing Schedule PH with its federal income tax return. If the PHC tax applies, the AET doesn't apply. The rules for the PHC tax are complicated. If you think your corporation might be affected, consult your tax advisor for guidance.
Bottom Line
Operating your business as a C corporation rather than a pass-through entity can be tax-smart. But beware of the AET and the PHC tax. Your tax advisor can help you avoid or minimize exposure to these taxes while you take advantage of today's favorable federal income tax regime.
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