The accumulated earnings tax: a practical approach to a subjective assessment.

The accumulated earnings tax (AET) is essentially a penalty imposed on corporations that accumulate earnings rather than pay them out as dividends. Historically, there were two reasons for the AET. First, the AET was intended as a mechanism to enforce the principle that corporate earnings were subject to double taxation - at the corporate level, and then at the shareholder level when distributed. Second, until the 1980s, the tax rate applicable to investment income of corporations was significantly lower than that of individuals. The AET provisions (Secs. 531-537), as well as the personal holding company tax provisions (Secs. 541-547), were intended to discourage generating investment income through a corporation.

This article will discuss the AET provisions with a view to what practical approaches to take when there is a substantial accumulation of income or when the issue is raised by the IRS. The AET issue, while not common, is an extremely important one in certain cases, since the amount of the assessment can easily become very large and, if it is assessed in one year, it is likely to be considered for assessment in earlier and later years.

Computation of Tax

Under Sec. 531, a 28 % tax is imposed on "accumulated taxable income," as defined in Sec. 535. Sec. 532(a) contains a "prohibited purpose" element, which provides that the AET will apply to a corporation "formed or availed of for the purpose of avoiding the income tax with respect to its shareholders or the shareholders of any other corporation, by permitting earnings and profits [E&P] to accumulate instead of being divided or distributed." The tax avoidance purpose need not be the only purpose for accumulating earnings - if it is only one of the purposes, the AET can be applicable. Sec. 532 states, in essence, that the AET applies to every corporation, except for personal holding companies, foreign personal holding companies, exempt organizations and passive foreign investment companies. S corporations are not subject to the AET by virtue of Sec. 1363(a), which states that, with exceptions not relevant here, S corporations are not subject to corporate Federal income tax. Foreign corporations are subject to the AET if their direct or indirect shareholders are subject to income tax because they are U.S. citizens or residents or nonresident aliens subject to Sec. 871.(1)

Under Sec. 533(a), an accumulation of earnings beyond the reasonable needs of the business is determinative of the prohibitive purpose of Sec. 532(a), "unless the corporation by the preponderance of the evidence shall prove to the contrary. "The fact that a corporation is a mere holding or investment company is prima facie evidence of the prohibitive purpose.(2) Dealings between the corporation and its shareholders, such as loans and withdrawals, corporate investments unrelated to its business, and the lack of a dividend history are factors in considering the existence of the prohibitive purpose.(3) Sec. 533 and the regulations there-under begin to get into the question of the burden of proof in AET cases, but it is Sec. 534 that fully addresses this issue. Since the imposition of the AET is, to a large degree, subjective, this issue is very important, and will be reviewed later.

Accumulated taxable income (ATI) is defined in Sec. 535(a) as taxable income as adjusted under Sec. 535(b), minus the sum of the dividends-paid deduction (as defined in Sec. 561) and the accumulated earnings credit (as defined in Sec. 535(c)). Thus, as a general rule, if a company has accumulated substantial earnings, but has a taxable loss (and no ATI) in the current year, there should be no current year AET exposure. The adjustments in Sec. 535(b) are intended to convert taxable income into "economic" income, i.e., what is actually available for distribution. Thus, for example, Federal income taxes and capital losses are deductible; charitable contributions are allowable without regard to the 10% limit; but net operating loss and dividends received deductions are not allowed. However, not all "economic" expenditures are deductible in computing ATI, e.g., suspended passive activity losses and penalties. Curiously, tax-exempt income is not taken into account in determining ATI.(4) In addition, capital gains are a deduction in arriving at ATI. To prevent double-counting, the capital gain deduction is reduced by the income tax attributable to the capital gain. For companies that engage in substantial capital transactions, the capital gain deduction is very advantageous; they can deduct the capital gains and, in effect, use the costs incurred in achieving those gains (broker commissions, investment adviser fees, etc.) as an offset against other income. Note, however, that mere investment or holding companies cannot deduct capital losses in computing ATI.(5)

For AET purposes, there are two elements to the dividends-paid deduction. First, dividends paid during the year are deductible in arriving at ATI. Sec. 563(a) allows dividends paid within 2 1/2 months after the year-end to relate back to that year.

Second, a deduction is allowed for consent dividends, described in Sec. 565, for the tax year. The consent dividend mechanism is a hypothetical distribution of a specified amount made by a corporation that has a reasonable basis to believe that it is subject to the AET.(6) The effect of the consent is to treat the specified amount as if it were a dividend to the shareholders at the end of the corporation's tax year, followed immediately by a paid-in capital contribution by the shareholders of such amount. The consent is irrevocable and is made on Form 972, Consent of Shareholder To Include Specific Amount in Gross Income, by the due date of the corporate return claiming the deduction. The purpose of the consent dividend is to help avoid the AET without having to impair the corporation's working capital by paying a cash dividend. Of course, the cash flow of the shareholders will be affected since they will be paying tax on phantom income. The deficiency dividends mechanism, described in Sec. 547, which is available to reduce or eliminate personal holding company exposure, does not apply to the AET.

Sec. 535(c) provides for an AET credit. The term "credit" is a misnomer, however; it is really a deduction in arriving at ATI and is not a credit against the AET itself. The credit is the greater of $250,000 ($150,000 in the case of certain service corporations) or the accumulated E&-P retained for the reasonable needs of the business. Mere investment or holding companies are entitled to a credit of only $250,000. Sec. 536 states that, in the case of a short tax year, ATI is not placed on an annualized basis.

Mitigating Factors

An accumulation of earnings beyond the reasonable needs of the business is a key element in determining whether a corporation will be subject to the AET. "Reasonable needs of the business" include the reasonably anticipated needs of the business and certain redemption needs with respect to a deceased shareholder or a private foundation.(7) The redemption provisions are important, but the focus of this article is on the most subjective element of Sec. 537, namely the present and reasonably anticipated operational needs of the business.

Regs. Sec. 1.537-1(a) states in part that an accumulation of E&P is unreasonable "if it exceeds the amount that a prudent businessman would consider appropriate for the present business purposes and for the reasonably anticipated future needs of the business." Thus, an IRS agent should give some leeway to the good faith business decisions of the company's management and should not substitute his own views on the best use of company earnings. The retention of E&P must be directly connected with the corporate business needs and the business purpose must be bona fide.

Regs. Sec. 1.537-1(b) discusses what constitutes a business's reasonably anticipated needs. The accumulated earnings need not be consumed within a short period after year-end as long as the accumulation will be used within a reasonable time, based on the facts and circumstances relating to the business's future needs. However, the need for an accumulation is based on facts as of the end of the tax year. The plans for the future must be specific, definite and feasible, not uncertain or vague. Subsequent events cannot be used to support the reasonableness of an earlier accumulation. However subsequent events may be relevant in determining whether there was an actual intent to consume the accumulation.

Thus, documentation - especially if contemporaneous - becomes an important tool in an AET case. Board of directors resolutions and corporate minutes should clearly identify specific uses of accumulated earnings, such as plant expansion, the acquisition of a related business, retirement of debt and the establishment of reasonable reserves for contingent liabilities. The amount of needed accumulation should be stated (as an estimate or as a range) and the method of calculating the amount (such as submitted proposals and bids) should be documented. The existence of such documentation will not necessarily cause the taxpayer to prevail, but its absence will help support the IRS position that there were no anticipated needs at the end of the tax year. When debt retirement is the purpose behind the accumulation, the IRS will more likely be persuaded that the accumulation is reasonable if the creditor is a bank or other third party and not a shareholder.

The state of the current economy affects the reasonableness of accumulations. If a company is in a business in which many customers or creditors have gone out of business or declared bankruptcy, there should be a greater need to keep earnings on hand to guard against a sudden business downturn. Similarly, if the business only has a few customers, it is more vulnerable to an economic downturn and should be entitled to accumulate additional earnings; this could also justify accumulating earnings for diversification. The courts have held that a reasonable accumulation to protect a company against a depression is a valid business purpose.(8)

The grounds for reasonable accumulations of E&P include providing for the bona fide expansion of the business or replacement of a plant; the acquisition of the stock or assets of another business; the retirement of business debt (including establishment of a sinking fund); providing working capital; providing for necessary investments or loans to suppliers or customers; or providing for payment of reasonably anticipated litigation, including product liability losses.(9)

Unreasonable accumulations are evidenced by loans to shareholders or using corporate funds for shareholders' personal benefit; loans having no reasonable relation to the business, especially if made to shareholders' relatives, friends or related corporations; investments that are unrelated to the corporation's business; or the retention of earnings to provide against unrealistic hazards.(10)

The Bardahl formula, named after the Tax Court case,(11) attempts to set an objective test for determining the working capital needs of the business, i.e., whether the taxpayer has enough working capital (or too much working capital) for a single operating cycle. A normal operating cycle is defined in the Internal Revenue Manual (IRM) as "the period of time required to convert cash into raw materials, raw materials into inventory of finished goods, finished goods inventory into sales and accounts receivable, and accounts receivable into cash."(12) The need for working capital is the limain reason" for accumulating earnings.(13) The IRM states that the "Bardahl formula is 'one test' and is not necessarily applicable to every [Sec.] 531 case; however, the operating cycle approach is a useful tool and should provide a basic facet of working capital considerations."(14)

Experience in tax audits has shown that the Bardahl formula is a double-edged sword. The problem is that it measures working capital, not cash. In reality, the payment of dividends - which is the whole purpose of the AET provisions - can be made only in cash. When the Bardahl formula works to a corporation's disadvantage, it is important to determine how much cash, on average, is available for distribution. Case law has held that a corporation should not he forced to incur debt or sell off business assets merely to pay dividends so as to avoid the AET.(15) The statement of cash flows may be useful in defending against an AET attack, because it highlights fixed assets acquired and other business investments made. Cash on hand at the end of the year may not be a fair reflection of the average of cash available during the year. In addition, bank covenants, which prevent the payment of dividends or require certain levels of working capital, should be taken into account since they evidence a nonprohibited purpose for accumulating earnings. However, lack of cash due to nonbusiness related activities, such as loans to shareholder's, will not help avoid AET exposure.

On the other hand, when the Bardahl formula indicates that the working capital needs are greater than the working capital available, weary IRS agents are sometimes willing to accept this as dispositive that no AET should be assessed, rather than investigating the other aspects of potential AET exposure.

Sometimes an IRS agent will attempt to tie in an AET case with an unreasonable compensation case. The agent's argument will be that compensation was unreasonable, which in turn caused a lack of cash. If the compensation were "reasonable," there could have been a dividend paid. There is no justification for such an argument. The taxpayer, or its representative, must insist that the reasonable compensation issue is separate from the AET issue.

Regs. Sec. 1.537-3 broadly defines "the business of the corporation" to include any line of business that it may undertake. However, investing in a subsidiary is not necessarily a reasonable accumulation of earnings. The subsidiary must have a business activity and not be a mere holding or investment company.

Burden of Proof

Given the fact that the potential assessment of the AET is almost entirely based on the facts and circumstances of each individual case, the question of who has the burden of proof is extremely important. In general, under Sec. 533, the burden of proof in determining whether the AET applies falls, in the first instance, on the taxpayer.(16)

However, if the issue is to be heard before the Tax Court, the rules of Sec. 534 apply. Under Sec. 534, the burden of proof that there has been an accumulation of earnings beyond the reasonable needs of the business shifts to the IRS if the Service fails to send the taxpayer a statement pursuant to Regs. Sec. 1.534-2(c), or if the taxpayer provides a statement in response to the IRS statement as provided in Regs. Sec. 1.534-(2)(d).

The IRS statement must notify the taxpayer that a proposed notice of deficiency includes an amount with respect to the AET. The statement must be sent by certified or registered mail any time before the mailing of the notice of deficiency. Thus, a 30-day letter, which is sent by ordinary mail, should not be sufficient. In a recent Tax Court case, Myco Industries,(17) the IRS statement failed to indicate the tax years for which the AET assessment was being proposed. The court held that the notice was not a valid statement under Sec. 534(b) and, accordingly, the burden of proof on the AET issue was on the IRS.

The taxpayer statement must state that no part of the earnings has accumulated beyond the reasonable needs of its business. The statement must indicate the grounds, together with relevant facts, to show that there has been no unreasonable accumulation. The statement must be sent to the IRS office that issued the IRS statement within 60 days after the Service mailed its statement. The taxpayer may request an extension of up to 30 days.

A taxpayer willing to pursue an AET case in the Tax Court, therefore, is assured of shifting the burden of proof to the IRS, assuming the procedures of Sec. 534 are complied with. This is a logical result, since the AET is basically a penalty imposed for wrongfully accumulating earnings. The burden of proof issue is also important at the audit level; the IRM states that the eventual shifting of the burden of proof to the IRS should be taken into consideration as the examination is conducted.(18)

Special Rules and Procedural Matters

The applicability of the AET to public companies is not clear. Sec. 532(c), added by the Deficit Reduction Act of 1984 (DRA), states that whether or not the AET applies "shall be determined without regard to the number of shareholders . . . ." The DRA Conference Report referred to this as a "clarification" that widely held companies are not exempt from the AET. However, the Conference Report continued, "as a practical matter it may be difficult to establish [a tax avoidance] purpose in the case of a widely-held operating company when no individual or small group of individuals has legal or effective control of the company."(19)

Special rules apply to consolidated return groups. Regs. Sec. 1.1502-43 provides, in general, that the AET issue is determined based on the, group as a whole. If a personal holding company is a member of the group, the consolidated AIST liability is reduced by the portion allocable to that member.(20)

The AET is somewhat unique among the taxes imposed by the Code in that its assessment is based on subjective criteria. It is therefore not readily subject to calculation under our self-assessment system of taxation. It is probably for this reason that, before 1986, interest did not run on an AET assessment if it was paid within 10 days of the IRS issuing a notice and demand for payment.(21) The Tax Reform Act of 1986 amended Sec. 6601 (b) (4) to provide that, for tax returns due after Dec. 31, 1985, interest would accrue from the original due date of the return. There is no IRS form for computing the AET and no line on the tax computation schedule (Schedule J) to indicate an AET liability. Accordingly, a taxpayer wishing to pay the AET with its return would have to attach a schedule computing the tax based on the accumulated earnings credit.

Sec. 6662 imposes a 20% "accuracy related penalty," which applies to, among other things, a substantial understatement of income tax, defined, in general, as the greater of 10% of the tax required to be shown on the return or, in the case of a C corporation, $10,000. The penalty can be avoided if the taxpayer has disclosed the position causing the understatement on the tax return on Form 8275, Disclosure Statement, or if the position is supported by substantial authority.(22) "Income tax" is defined as a tax imposed by Subtitle A (Secs. 1-1563) of the Code.(23) There is no authority on whether the Sec. 6662 penalty could apply to the AET, and due to its inherently factual nature, it may be difficult to find substantial authority to support an accumulation of earnings. Accordingly, it would be advisable to consider the inclusion in a tax return of a disclosure statement (Form 8275) if there may be any AET exposure. Since, by its nature, the AET is likely to be a recurring item, disclosure may be required in each year in which there is a potential liability.(24)

Summary

Under the Code, there is a two-part test to determine whether there is any AET exposure. First, the corporation must have been formed or availed of for the purpose of avoiding income tax, and second, there must have been an accumulation of earnings beyond the reasonable needs of the business. When the AET issue is raised by an IRS agent via an Information and Document Request, the taxpayer should consider responding as completely as possible, including preparing a Bardahl formula and documenting the reasons for the need to accumulate, earnings. This serves two purposes: it may convince the agent that no AET should be assessed, and it helps lay the foundation for shifting the burden of proof to the IRS.

(1) Regs. Sec. 1.532-1(c). (2) Under Regs. Sec. 1.533-1(d), special rules apply to small business investment companies. (3) Regs. Sec. 1.533-1(a)(2). (4) Rev. Rul. 70-497, 1970-2 CB 128. (5) Sec. 535(b)(8). (6) Regs. Sec. 1.565-1(a). (7) Sec. 537(a). (8) See, e.g., Mellbank Corp., 38 BTA 1108 (1938). (9) Regs. Sec. 1.537-2(b). (10) Regs. Sec. 1.537-2(c). (11) Bardahl Manufacturing Corp., TC Memo 1965-200. (12) IRM 4233, [paragraph] 638.1(2). (13) IRM 4233, [paragraph] 638.2(l). (14) IRM 4233, [paragraph] 1638.2(4). The Bardahl formula, as used by the IRS, is reprinted in IRM 4233 at Exhibit 600-2. (15) C.E. Estes, Inc., TC Memo 1980-504; Sandy Estate Co., 43 TC 361 (1964). (16) Regs. Sec. 1.533-1(a)(1), second sentence; Regs. Sec. 1.533-1(b), second sentence. (17) Myco Industries, Inc., 98 TC No. 21 (1992). (18) IRM 4233, [paragraph] 63(10)(2). (19) H. Rep. No. 98-861, 98th Cong., 2d Sess. 829 (1984). (20) Regs. Sec. 1.1502-43(b)(3). (21) See Rev. Rul. 72-324, 1972-1 CB 399. (22) Regs. Sec. 1.6662-4(e) and (f). (23) Regs. Sec. 1.6662-4(a). (24) Regs. Sec. 1.6662-4(f)(3).