What Is an Accumulated Earnings Tax?
An 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. The IRS allows for certain exemptions to the tax rule.
Key Takeaways
- An accumulated earnings tax is a tax on retained earnings that are considered unreasonable, which should be paid out as dividends.
- The government taxes accumulated earnings so as to prevent corporations from not paying dividends to its shareholders.
- Dividends are taxed higher than capital gains so it is financially beneficial for shareholders to avoid paying taxes on dividends.
- The accumulated earnings tax rate is 20%.
- Exemption levels in the amounts of $250,000 and $150,000, depending on the company, exist.
- The IRS also allows certain exemptions based on the required need for the accumulated earnings.
Understanding an Accumulated Earnings Tax
Corporations that accumulate their earnings or profits, instead of distributing them as dividends to shareholderswill be subjected to the accumulated earnings tax if the amount of earnings retained is above a certain level. These companies may accumulate earnings of 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. The accumulated tax rate is 20% of the accumulated earnings.
Reason for an Accumulated Earnings Tax
The government imposed the accumulated rate tax to deter shareholders from negatively influencing a company’s decision to pay dividends and thereby avoiding having to pay taxes on dividends. If a company does not distribute any dividends by keeping a portion of retained earnings as accumulated earnings, shareholders are able to avoid this tax.
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 government will either collect more taxes from the company or persuade them to issue dividends, thereby, allowing the government to collect from the shareholders.
Accumulated Earnings Tax Exemptions
A corporation has an exemption amount of $250,000. This means that a minimum accumulation earnings of $250,000 is allowed, and any amount that exceeds the exemption is taxed at 20%. For companies whose principal function is performing services in the fields of accounting, actuarial science, architecture, consulting, engineering, health, law, and the performing arts, the exemption amount is $150,000.
A corporation that has an accumulation of earnings may be liable to pay the accumulated earnings tax unless the business can show that the earnings over the threshold are for reasonable needs of the business, some of which the Internal Revenue Service (IRS) defines as:
- “Specific, definite, and feasible plans for the use of the earnings accumulation
- Product liability loss where the accumulated amount is needed for the payment of reasonably anticipated product liability losses
- Various redemption needs”