If your business is set up as a C corporation, you are generally subject to federal income tax on the corporation’s taxable income. Then the shareholders would be subject to individual income tax on any dividends or distributions they receive from the corporation. This is what is referred to as double taxation.
A corporation could avoid the individual income tax on the shareholders by not making distributions and retaining the earnings within the corporation. But this applies only up to a certain point. If more than a certain amount of earnings are retained in the corporation and not distributed, an accumulated earnings tax could apply.
The accumulated earnings tax is 15% and if the tax applies, interest accrues on the tax from the date the corporate income tax return was originally due, without extensions.
According to the IRS, the accumulated earnings tax would apply if there are accumulated earnings of more than $250,000 in a corporation. In a personal services corporation the limit is $150,000. This includes businesses such as accounting and legal firms, architects, consultants, engineers, health care, and the performing arts.
These amounts are the limits set by the IRS to generally determine whether a corporation is accumulating earnings to meet the reasonable needs of the business, such as a possible expansion or other bona fide business purpose. According to CBIZ, a business and financial services company, over the years the IRS and the courts have used several different criteria to determine whether earnings are accumulated in order to avoid taxes or for the reasonable business needs of the company.
The IRS can review the trial balance filed by the corporation on its income tax return and may review the minutes of board of directors meetings or other documentation to determine how the company intends to use the accumulated earnings.
Then it must be determined that the accumulated earnings are for reasonable business needs. These could include working capital needs, payment of accrued taxes, business expansion, the purchase of assets, major litigation or other contingencies, the retirement of long-term debt, and stock redemptions.
Therefore, one of the ways to avoid the accumulated earnings tax is to be able to demonstrate that the accumulated earnings are reasonable. As pointed out by the Business Owner’s Toolkit, another way to ensure that the accumulated earnings tax does not apply is by paying higher salaries to the owners, which would be tax deductible for the corporation, or by actually investing the earnings back into the business.
Other possibilities for avoiding the accumulated earnings tax that may apply for smaller, closely-held companies would be to consider other legal structures, such as a limited liability company (LLC), or to elect subchapter S status. An S corporation is a pass-through entity, treated similar to a partnership, and all the earnings are taxable only to the shareholders.
Sources:
Accumulated Earnings Tax, Business Owner’s Toolkit
Accumulated Earnings Tax – Warning, Your Company May Be At Risk, CBIZ
Publication 542, Corporations, IRS