IRS eyeing excess accumulated earnings

Business taxes as C corporations can expect the IRS to be taking a very close look at the level of accumulated earnings over the next several years.

There are many reasons corporations decide to not pay dividends to shareholders. Uncertain economic conditions have led many businesses to conserve cash over the last decade. Higher dividend rates have provided an additional incentive for corporations to hold on to cash because a distribution of earnings via a dividend is not deductible by the corporation and, therefore, represents the classic “double tax” scenario to which C corporations are subject.

The IRS, however, can effectively compel C corporations to make nondeductible dividend distributions. If a determination is made that the business is accumulating earnings to avoid the tax payable on dividends, the IRS can impose an “accumulated earnings tax” on the corporation, at the same rate imposed on dividend income. Once the IRS examiner asserts that there is an unreasonable accumulation of earnings, the burden is generally on the taxpayer to show that such accumulation was reasonable given the needs of the business.

The tax can be avoided if the corporation can show that the accumulation is not to avoid paying dividends, but to prepare and provide for legitimate business reasons such as the expansion of a facility, acquisition of another business, or debt retirement, among other reasons. It is therefore important to document these needs each year, ideally in the minutes of the shareholders’ or directors’ meeting.

The company is also allowed to retain a sufficient amount of earnings to provide working capital to the business as determined by a formula known as the “Bardhal Formula.” This formula takes into account the capital needed for the business by looking at the business operating cycle and the cash needed to operate the business for a taxable year.

Because of the many factors that go into the analysis, it is important to have a comprehensive plan that takes into account (and documents) the needs of the business, from both a working capital and a future needs basis, along with establishing a dividend paying policy. The amount of IRS attention to this issue has varied over the years. This was a significant issue in prior years when capital gains were taxed at a rate that was lower (and in some cases much lower) than dividend rates. It seems as though the IRS was less likely to focus on this issue in more recent years when dividend rates were very low. With the recent increase in dividend rates, this issue will be coming up more frequently in audits and should therefore again be an important planning item for corporations.

This and other tax issues will be the topic of discussion at our upcoming Business Hour event – Top tax issues and planning ideas for 2015. Join us for a discussion on the latest tax updates, strategies, and insights by registering to attend our Business Hour or to watch the live webcast so you can start planning for 2015 taxes now.