Tags: Tax

Beware the Corporate Accumulated Earnings Tax

20 December 2023

The flat 21% corporate federal income tax rate ushered in by the Tax Cuts and Jobs Act made the idea of operating your business as a C corporation more attractive than before. The flat 21% rate applies to both "regular" C corporations and C corporations that are classified as personal service corporations.

When you compare the 21% corporate rate with the current 37% maximum federal income tax rate for individual taxpayers, you can see why C corporation status seems alluring. But there's more to the story.

C corporations face some tax issues that don't affect other types of businesses, including sole proprietorships, single-member limited liability companies (LLCs) treated as sole proprietorships for tax purposes, partnerships, multi-member LLCs treated as partnerships for tax purposes and S corporations.

Here's what you need to know about the accumulated earnings tax (AET), which is a potential negative of running your business as a C corporation.

Double Taxation of Corporate Dividends

If your C corporation is successful, it can build up a hefty amount of earnings and profits (E&P). This is a tax accounting concept that's similar to the financial accounting concept of retained earnings.

While significant E&P indicates a financially healthy operation, it also creates tax concerns when you try to get money out of the company. That's because, to the extent of a corporation's E&P, corporate distributions paid to shareholders will constitute taxable dividends.

When you have taxable dividends, it results in double taxation of corporate earnings: once at the corporate level and again at the shareholder level when earnings are distributed as taxable dividends. Other things being equal, double taxation is something to avoid.

AET Can Be Assessed If Dividends Aren't Paid

You might wonder if your C corporation can avoid double taxation by simply not paying dividends. Unfortunately, the Internal Revenue Code doesn't allow that strategy to work. When your C corporation retains a significant amount of earnings rather than paying them out as double-taxed dividends, there's a risk the company will get hit with AET.

AET is a corporate-level tax assessed by the IRS, as opposed to a tax that is paid voluntarily with your company's federal income tax return. The IRS can assess AET when:

The corporation's accumulated earnings exceed $250,000 ($150,000 for a personal service corporation), and
The corporation can't demonstrate economic need for the "excess" accumulated earnings.

When AET is assessed, the rate is the same as the maximum federal rate on dividends received by individual taxpayers — currently 20%. AET is effectively a backdoor way to achieve double taxation. Be aware that while the current AET rate is 20%, it could be higher in the future if dividends are once again taxed at higher ordinary income rates as they previously were.

Strategies to Combat AET

Here are three possible ways to avoid or minimize exposure to AET.

1. Document reasonable business needs. Perhaps the easiest way to avoid or minimize exposure to AET is to show that your corporation doesn't have accumulated earnings in excess of the AET threshold. For this purpose, you can reduce your corporation's accumulated earnings for funds that the company reasonably needs to retain to pay for, among other things:

Expansion of the business,
Acquisition of a business,
Retirement of debt, and
Working capital needs.

Your tax advisor can help you to quantify your corporation's reasonable business needs for funds.

2. Pay dividends while tax rates are low. The current federal income tax rate on dividends received by individuals can't exceed 23.8% — the 20% maximum rate plus another 3.8% for the net investment income tax. So, dividends paid while the current rates are in force will be taxed lightly by historical standards. If the tax rates on dividends increase in the future, C corporation status won't be as attractive as under the current tax regime, because the cost of double taxation will be higher.

Another advantage of paying out dividends while tax rates are relatively low is that it reduces your corporation's accumulated earnings balance. So, paying out dividends can have the beneficial side effect of reducing or eliminating your corporation's exposure to AET in future years when the AET rate could be higher.

3. Redeem stock while tax rates are low. The general rule is that cash payments by a corporation to redeem (buy back) its stock shares are treated as corporate distributions to the recipient shareholder. As such, the payments are treated as taxable dividends to the extent of the corporation's E&P. Once E&P has been exhausted, any remaining redemption payments reduce the shareholder's tax basis in the redeemed shares. Once basis has been exhausted, any remaining redemption payments constitute capital gain for the shareholder.

So, individual C corporation shareholders will get historically favorable federal income tax treatment for stock redemption payments received in 2023, even if the payments are treated as taxable dividends.

In addition, stock redemption payments that are treated as taxable dividends will reduce your corporation's accumulated earnings balance. That can have the beneficial side effect of reducing or eliminating your corporation's exposure to AET in future years when the AET rate could be much higher.

For More Information

Operating your business as a C corporation, rather than as a pass-through entity, can be a tax-smart move. But beware of AET. Also be wary of the possibility of future unfavorable changes to the federal income tax regime that could make C corporation status less attractive. Consult your tax advisor for help in avoiding or minimizing exposure to AET, while taking advantage of today's favorable federal income tax regime.

Please reach out to our Tax Team for more information.

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