Accumulated Earnings and Deferred Compensation

ACCUMULATED EARNINGS

The profits of any business are subject to corporate income tax. When any portion of these profits is distributed to stockholders, the distribution is also taxed as income to the stockholder. In most people’s eyes, this is a case of “double taxation.”

Q: How can a company minimize this double taxation?

A: Don’t distribute earnings as dividends; keep them in the corporation as retained earnings.

Advantages of Retained Earnings

Retaining earnings has a number of advantages:

• Smooth out profits. Distributions can be timed to even out years of high and low profits.
• Stockholders’ tax savings. Distributions can be timed to take advantage of years in which the major stockholders’ income tax bracket is lower.
• Enhance company value. Retained earnings increase the value of the corporation. These funds can be used to expand or improve the corporation's operations and, typically, the market value of the stock will also increase. This presents an opportunity for stockholders to sell shares of the stock according to their timing, and pay capital gains on the proceeds rather than treating them as ordinary income.
• Repurchase stock. The corporation can use accumulated earnings to buy back outstanding shares of stock. This increases the earnings per share of the remaining stock, which is generally a positive indicator of performance.
• Estate taxes. If the stock is held until the death of the stockholder, the heirs receive a step-up in basis to the fair market value on the date of death. This allows them to avoid any taxation on the increased value of the stock due to the accumulated earnings.
• Step-up in Basis. The readjustment of the value of an appreciated asset for tax purposes upon inheritance. With a step-up in basis, the value of the asset is determined to be the higher market value of the asset at the time of inheritance, not the value at which the original party purchased the asset.

Example: Step-up in Basis

Mr. Skywaltzer is the sole shareholder of Skywaltzer, Inc., an "S" corporation created to develop an invention to sniff out illegal drugs at airports. Mr. Skywaltzer contributes $30,000 in capital and has a $30,000 basis in his "S" stock. Skywaltzer dies unexpectedly in December 2025 and at the time of his death, the basis in his "S" stock increased to its Full Market Value, which is $2,500,000.

Skywaltzer's family is offered $2,500,000 for the corporation's assets. At the time, the corporation's basis in its assets - the "inside" basis - is $30,000. If this offer is accepted during 2026, the Corporation will have taxable gain from the sale of the corporate assets of $2,470,000 ($2,500,000 - $30,000). This gain will pass through to Mr. Skywaltzer's heirs, who are now the "S" corporation shareholders, and they will have to pay tax on that gain in 2026. What happened to the benefit of the step-up in basis on Skywaltzer's death?

As of the date of Skywaltzer's death, the heirs' basis became $2,500,000. After the asset sale, the basis was increased to $4,970,000 (the original date of death basis plus the $2,470,000 of gain passed through to the heirs). Regardless of whether all of the proceeds of the sale are distributed in 2026, the heirs will still have to pay tax on the $2,470,000 gain. Up to this point, the heirs cannot take advantage of the step-up in basis resulting from Skywaltzer's death.

The only way the heirs can be sure to benefit from the step-up in basis is to liquidate Skywaltzer, Inc. in 2026. They will recognize a loss on the liquidation that will offset the gain on the corporation's asset sale. Hence, the sale will become largely tax-free to the heirs.

This loss happens because the heirs' basis in their stock (after the asset sale) has become approximately, $4,970,000, and on the liquidation they will be receiving sale proceeds of approximately $2,500,000 (ignoring the effect of state and local taxes, commissions, etc.) The difference between their basis - $4,970,000 - and the $2,500,000 distribution will generate a loss of $2,470,000, which will offset the capital gain on the corporation's asset sale.

Q:Which companies use accumulated earnings?

A:Closely held corporations are likely to use accumulated earnings and this practice is particularly true of growth companies.