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Tax Treatment
The government does not view the accumulation of earnings as a good thing.
According to the government, the accumulation of earnings beyond the "reasonable needs of the company" is an evasion of taxes. The government’s position on the accumulation of earnings isn’t new. There were restrictions on the accumulation of earnings in the first income tax laws passed under the 16th amendment in 1913.
Today, there is an Accumulated Earnings Tax (AET) on top of the corporate income tax.
The AET rate through 2026 is 20% of all retained earnings (with limits).
There is also a Personal Holding Company (PHC) tax that may be imposed in certain circumstances. This will be discussed later on in the course.
Accumulated Earnings Tax
Q:What’s the purpose of the Accumulated Earnings Tax?
A: To prevent corporations from saving their shareholders from having to pay tax on distributions to them in the form of dividends. The tax is based on the amount of accumulated retained earnings and the intent is not to penalize all retained earnings — just those in excess of the bona fide needs of the corporation. The risk of AET being imposed is more likely for closely held corporations than publicly held corporations.
The company's intent
Intent is an important factor in the imposition of the AET, and in the context of prima facie financial statements such a tax can be triggered.
| Prima facie | obvious, evident at first sight without further proof. |
|---|
This intent may not be the dominant motive or even the controlling motive in triggering the application of the tax; it need only be a contributing factor. Thus, accumulation beyond reasonable business needs is perceived to be “bad” unless reasons can be shown otherwise. Certain corporations (such as holding or investment companies) are still subject to the tax but have special rules in determining adjusted taxable income.
The question is…
Did the corporation intend to retain the earnings in order to avoid the tax on dividends?
Exempt corporations
The following types of organizations are not taxed under the AET provision:
- S corporations
- foreign personal holding companies
- personal holding companies
- passive foreign investment companies
- tax-exempt organizations
Imposition of the tax
The tax is levied upon the current year’s addition to the retained earnings less the amount needed for reasonable business purposes.
This tax is in addition to the regular corporate income tax.
Memory Jogger
The AET is imposed when the intent of retained earnings is to: