Does Network Systems indicate a new tolerance for accumulated earnings by some courts?

The goal of the accumulated earnings tax (AET) is to cause corporations to either distribute earnings currently (which will then be taxable to the shareholders) or risk having to pay a corporate substitute for the shareholder level tax. In addition, the AET also strengthens the prohibition against accumulating investment earnings in a corporate shell, particularly if the economic benefit of those earnings is made available to the corporation's shareholders.

Rather than being a self-assessed tax, the AET is imposed by the IRS on audit when the shareholders of a corporation are viewed to have engaged in certain proscribed actions. The tax is calculated by determining each year what portion of current earnings (i.e., current taxable income with certain adjustments) was unreasonably retained rather than paid out to shareholders, and then levying a 28 % tax on that portion. The proscribed actions are the forming or availing of a corporation for the purpose of tax avoidance by the shareholders or the shareholders of any other corporation by permitting the corporation's earnings and profits (E&P) to unreasonably accumulate rather than be distributed. in assessing the AET, the Service only needs to show that one of the purposes for the forming or availing of the corporation is tax avoidance. It is also important to remember the very subjective nature of this determination.

Given this subjective nature, the courts have played a significant role in determining the application of the AET. The courts have spent considerable time attempting to measure excess net current assets to determine whether dividends should have been paid to shareholders. However, liquidity alone does not indicate tax avoidance. Under the AET rationale, retained current year and/or accumulated E&P from prior years are necessary to determine that shareholder taxation has been avoided. However, the courts and the Service generally have accepted that, as long as the retained (accumulated) earnings are used by the corporation in its business, tax avoidance is not present. Aside from obvious business investments such as plant and equipment, every business requires working capital. Although the courts have historically agreed that a certain amount of net current assets is required in every business, it was not until Bardahl Manufacturing Corp., TC Memo 1965-200, that mathematical analysis was introduced in an attempt to remove some of the subjectivity in determining how much working capital is required for reasonable business needs.

The Bardahl analysis allows a business to retain enough working capital to fund its production and receivables collection for one "operating cycle," and provides a formula approach for determining such amount. Given the wide variety of business and factual situations (e.g., service versus manufacturing), and the various opinions as to the exact application of mathematical analysis, Bardahl brought only a degree of certainty to the outcome of an AET case, even given the IRS's concession that working capital is an acceptable reason for accumulating earnings as liquid assets. Many courts have wrestled with the issue of operating cycle determination and the weight accorded it when determining the presence or lack of unreasonable accumulations. But even after justifying accumulation of earnings to fund one operating cycle, what remains to be considered are the often greater questions of what "cushion" is required for contingencies and what amounts are required for opportunities that may be only somewhat remote possibilities at the end of a particular year.

The Internal Revenue Manual (IRM) contains the Bardahl formula, but it instructs field agents to consider other factors in determining whether unreasonable accumulations exist. The IRM lists various "reasonably anticipated needs of the business," including contingencies such as lawsuits, contractual obligations, loss of customers (i.e., "business reversals"), reserves to guard against competitive pressures, and self-insurance and retirement plans. In addition to these contingencies, a corporation will be allowed to accumulate earnings for retiring debt as long as it is bona fide and related to the business. Furthermore, the Service cannot force a corporation to incur debt; therefore, accumulating earnings for future business expansion is allowed.

Although the court in Mellbank Corp., 38 BTA 1108 (1938), recognized that the state of the banking business through the Depression required retention of the holding company's earnings to minimize additional capital contributions required to protect the corporation's business investments in operating banks, this reason for accumulating earnings as a defense against assessment of the AET has not been common. (See also A.F. Gallun & Sons, 510 F Supp 630 (DC Wisc. 1981).)

However, in a recent case, Network Systems Corp., DC Minn., 1993, the district court found that the IRS focused too heavily on the significant amount of net current assets and did not consider the nature of the business when determining reasonable business needs. In particular, the taxpayer had retained the proceeds from two stock offerings and apparently had not deployed the bulk of this amount in its business. The court offered several instances of public high technology companies that had either failed or were having difficulty due to market risks associated with the industry; in light of this business environment, it was not surprised that certain corporations might have net liquid assets in excess of E&P. The court rejected an IRS theory that the AET was intended by Congress to encourage the circulation of money, regardless of whether its source could be traced to operations, profits or paid-in capital.

Although the lesson of Network Systems appears to be that AET cannot be levied on paid-in capital, taxpayers should note the court's discussion of industry risk. It remains to be seen whether other AET cases will be decided in favor of taxpayers when the specific risks of their industry are accepted as a reason for accumulating E&P.

The Service appears to have become more aggressive in the AET area, even when the taxpayer is a public corporation with many shareholders (as is the case in a number of AET cases, including Network Systems). Consequently, it is important for taxpayers and their advisers to be aware of the defenses against an AET assessment. Beyond having a Bardahl analysis prepared for each year-end, taxpayers should be thoughtful in their discussions and conscientious in their documentation of corporate finances, business plans, industry conditions, etc., so that these reasons can be used to justify the retention of earnings. Thus, if an examining agent requests information directed at the AET, the taxpayer may be able to head off a problem before it gets started by convincing the examining agent that the taxpayer has a strong defense against an AET assessment.