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The accumulated earnings tax.

The accumulated earnings tax applies to corporations formed or used for the purpose of shielding their shareholders from income taxes. This purpose does not have to be the only reason for accumulating earnings; it only has to be one of them.

The tax applies to all corporations except personal holding companies, foreign personal holding companies, exempt organizations and passive foreign investment companies, all of which are subject to special rules. S corporations are not subject to the tax, and there is a question about its applicability to publicly held companies (in which no individual or small group of individuals has effective control). As a practical matter, the tax is imposed almost exclusively on closely held corporations. Accordingly, these corporations should be prepared to demonstrate that earnings were not accumulated to avoid taxation.

REASONS FOR

ACCUMULATING EARNINGS

The accumulated earnings tax essentially is a penalty imposed on corporations for accumulating earnings rather than distributing them to shareholders as dividends. Traditionally, corporations have accumulated earnings for two tax reasons: (1) If paid out as dividends, earnings are taxed twice, originally as income to the corporation and again as dividend income to the shareholders. (2) Until recently, the tax rate for corporate investment income was significantly lower than the tax rate for individuals.

The main business reason for accumulating earnings is a corporation's need for sufficient working capital. Corporations must demonstrate that they have enough - but not too much - working capital for a single operating cycle.

REASONABLE NEEDS OF A

BUSINESS

A corporation is considered to have accumulated earnings for a tax-avoidance purpose if the earnings exceed its reasonable needs (including its anticipated needs). Transactions between a corporation and its shareholders (such as loans, withdrawals or expenditures of corporate funds for shareholders' personal benefit), corporate investments in assets having no reasonable connection with the business and a lack of dividend history are all factors that may be considered in this determination.

Note: A corporation's business includes any line of business it may undertake. However, it does not include acting as a holding or investment company, which is prima facie evidence of a tax-avoidance purpose. If a corporation invests in subsidiaries, the subsidiaries must have business activity.

Reasonable business needs may include

* Expanding or replacing plant or equipment.

* Acquiring a business enterprise by purchasing assets or stock.

* Retiring bona fide business debt.

* Building up working capital for inventories.

* Investing in (and lending to) suppliers or customers.

* Responding to competition.

* Funding employee pension or profit-sharing plans.

* Establishing reserves for business risks and contingencies.

* Providing self-insurance to key personnel.

* Meeting surety bonding needs.

* Providing for reasonably anticipated product liability losses.

* Redeeming private foundations' excess business holdings.

* Redeeming a deceased shareholder's corporate stock.

REASONABLY ANTICIPATED

NEEDS

A corporation must have specific, definite and feasible plans to demonstrate its reasonably anticipated needs. Obviously, documenting these plans is critical. While documenting needed accumulations (in terms of both amount and the method of calculation) does not always resolve the issue, certainly failing to do so will substantially weaken the corporation's position.

For a discussion of the problems in this area, see "The Accumulated Earnings Tax," by Michael Goldberg, in the March 1993 issue of The Tax Adviser.
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Title Annotation:from 'The Tax Adviser'
Author:Fiore, Nicholas J.
Publication:Journal of Accountancy
Date:Mar 1, 1993
Words:527
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