Accumulated Earnings Tax

Accumulated Earnings Tax
See also
Ownership interest Entity theory Company limited by guarantee Revenue reserve Separate property Risk retention group Corporate opportunity doctrine Statutory meeting Fixed and floating charge

Accumulated earnings tax is a tax imposed by the government. The shareholders of a corporation tend to accumulate their profits in order to avoid tax and the accumulated earnings tax was created to keep them from doing it and inspire them to rather use their earnings to issue dividends. It is introduced in addition to usual corporate income tax. It is imposed with a rate of 20 percent on amounts presumed to be unreasonable aggregations of earnings. Accumulated Earnings Tax has existed in some form since 1913 (Madeo A.S, 1979, p.538).

With the exception of service corporations, for instance accounting, law and health care corporations, all corporations's first $250, 000 in accumulated earnings is exempt from tax. The first $150,000 of the service corporations shall not be taxed. The tax will not be imposed on accumulations, that can be considered mandatory to meet understandable needs of the business, even after the accumulated earnings of a corporation exceed the exemption tally.

The accumulated earnings tax can not be imposed at the same time as personal holding company Tax. It has the priority (Whittenburg G.E, Gill. S, Altus-Buller. M, 2017).

Example of the accumulated earnings tax

"Alder is a manufacturing corporation that has accumulated earnings of $625,000. The corporation can establish reasonable needs for $450,000 of this accumulation. Alder Corporation would be subject to the accumulated earnings tax on $175,000 ($625,000-$450,000). The amount of the accumulated earnings tax is $35,000 (20% of $175,000)." (Gerald E. Whittenburg, Steven Gill and Martha Altus-Buller, 2017).

Differences in individual and corporate tax rate

The differences are thin enough to generate a temptation to use a corporation "as a shield against individual income tax". That is why the Congress made a move and disposed of this temptation by taxing the shareholders of offending corporations. Today's accumulated earnings tax is a spiritual successor to this early legislation (Doernberg R.L, 1981, p.715)

Enforcement process of the accumulated earnings tax

There are three parties that are interested in how the law in enforced. These are; Congress, The Treasury Department and taxpayers. There are also at least three stages in this process that can help determining the factors of these parties (Madeo A.S,1979, p.538):

• "The first stage - the point at which taxpayers are audited for possible accumulated earnings liability."
• "The second stage - the point at which taxpayers actually receive assessment from the Internal Revenue Service."
• "The third stage - the point at which cases are decided at court."

(Madeo A.S, p.538)

Definition by one od the scholars

According to scholar Homer L. Elliot accumulated earnings tax is often referred to as "a penalty on success itself". In his opinion, of all existing taxes, this is the most infamous one, including an after the fact conclusion on management's business judgement. " As long as substantial differences exist in the tax rates imposed upon the corporation on the one hand and upon the individual on the other, however there will continue to be a need for such tax "as a barrier to...tax avoidance" (Homer L. Elliot, 2019).

Advantages of Accumulated Earnings Tax

Accumulated Earnings Tax is a tax imposed by the government on corporations which accumulate their profits in order to avoid taxation. It is introduced in addition to usual corporate income tax and has the following advantages:

• It prevents companies from accumulating too much of their profits and encourages them to pay dividends to shareholders. This encourages companies to reinvest their profits and stimulate economic growth.
• It encourages companies to remain small or medium-sized as large companies tend to accumulate more profits. This helps promote economic competition and prevents monopolies.
• It ensures that companies are paying their fair share of taxes, which is beneficial to both the government and the general public.
• It discourages companies from using their profits for speculative purposes, such as investing in risky investments or entering into high-risk transactions. This helps protect the investments of the company’s shareholders.

Limitations of Accumulated Earnings Tax

Accumulated Earnings Tax is a powerful tool to deter corporations from keeping their profits and avoid paying corporate income tax. However, it also has some limitations. These include:

• Difficulty in determining what is an unreasonable accumulation of earnings: The difficulty in determining what is an unreasonable accumulation of earnings makes it difficult to enforce the law.
• Lack of current information: The information used to determine the tax rate is often outdated, which can lead to inaccurate taxation.
• Unclear criteria for determining an accumulation of earnings: The criteria for determining an unreasonable accumulation of earnings is often vague and can lead to an unfair tax burden.
• Tax avoidance: Corporations can use certain strategies to avoid the tax, such as shifting profits to other countries or to other forms of income.
• Potential for double taxation: In some cases, the same income can be subject to both the corporate income tax and the accumulated earnings tax.
• Lack of efficiency: The tax can be expensive to enforce and collect, and can be inefficient in its ability to generate revenue.

Other approaches related to Accumulated Earnings Tax

To prevent shareholders from accumulating profits in order to avoid taxes and inspire them to use the earnings to issue dividends, the government has implemented several approaches in addition to the Accumulated Earnings Tax. These include:

• Taxation of retained earnings: This approach taxes the amount of earnings retained by a corporation, rather than the total accumulated earnings.
• Corporate capital gains tax: This approach taxes the increase in value of corporate assets due to inflation or appreciation.
• Corporate dividend tax: This approach taxes the dividends paid out by a corporation.
• Corporate income tax: This approach taxes the net income of a corporation.

In conclusion, the government has implemented several approaches to prevent shareholders from accumulating profits in order to avoid taxes and inspire them to issue dividends instead. These include taxation of retained earnings, corporate capital gains tax, corporate dividend tax, and corporate income tax.

References

• Doernberg R.L, (1981), The accumulated earnings tax: the relationship between earnings and profits and accumulated taxable income in a redemption transaction, Florida law review 34, p.715 Heinonline
• Elliot L.H, (2019), The accumulated earnings tax and the reasonable needs of the business: A proposal, William & Mary Law Review 34, p.2, Heinonline
• Madeo A.S, (1979), An empirical analysis of tax court decisions in accumulated earnings cases, The accounting review vol.54, nr.3, p.538 JSTOd
• Whittenburg G.E, Gill. S, Altus-Buller. M, (2017), Income tax fundamentals 2017, San Diego State University, USA

Author: Jakub Winiarski