Business Owners Would Be Wise to Remain Mindful of the Cost of Excessive Accumulated Earnings

Many personal financial counselors and experts wisely counsel individuals and couples put away a substantial “rainy day fund” to guard against financial crises and other emergencies. Indeed, many business people followed a similar strategy in the weeks and months after the economic downturn, so much so that in late 2009, the Wall Street Journal reported that businesses were holding more proportionately more of their assets in cash than at any time in the last 40 years. However, saving up too much cash in the company’s coffers can prove costly. That’s because doing so may trigger a rarely publicized penalty known as the accumulated earnings tax.

The accumulated earnings tax is a penalty tax. The tax code imposes this penalty tax on C corporations with large accumulations of cash based upon the theory that companies holding what the government considers earnings in excess of “the reasonable needs of the business” likely do so as a means of evading or deferring shareholders income taxes that they would have realized if the corporation distributed more of its cash. The goal of the tax is to encourage timely payment of dividends.

The Internal Revenue Service treats as “reasonable” accumulations of $250,000 or less (or $150,000 or less if the corporation is a personal services business, such as a accountant, actuary, architect, consultant, engineer, veterinarian, attorney or performing artist). The IRS will also look into the reasonable needs of a corporation to determine if the tax applies. The IRS describes reasonable needs as including: “specific, definite, and feasible plans for use of the earnings accumulation in the business” and the “amount necessary to redeem the corporation’s stock included in a deceased shareholder’s gross estate.” If your company operates in an industry that is particularly unstable, accumulating larger cash reserves may be more defensible than it would be in other fields. Additionally, if you are storing reserves as part of a major business initiative, such as expansion, moving those plans forward into a tangible or “blueprint phase” as swiftly as possible may prove beneficial. In addition to proving that earnings were reasonable, corporations avoid liability under this tax by reducing earnings through a variety of methods, such as raising the salaries of the corporation’s owners or investing in the business.

Obviously, some of these standards are less than bright-line in nature, but as long as your business is below the $250,000 (or $150,000) threshold, it does not owe the tax. The tax stood at a rate of 15% in 2012, but was scheduled to skyrocket to 39.6% in 2013. The American Taxpayer Relief Act altered the tax’s rate, permanently setting at 20%.

Businesses face a large and ever-changing number of obligations regarding tax compliance, including sales taxes. To make certain your business is properly collecting all taxes, consult the experienced tax attorneys at Samuel C. Berger, P.C. and CPAs at S.C. Berger, P.C., who have a long background of helping businesses throughout New York and New Jersey. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.

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