The IRS is reporting an uptick in accumulated earnings tax audits of C Corporations. This is a pretty obscure tax, but it does carry a hefty penalty if you aren’t following the rules.
If you’ve never heard of this tax, you’re not alone. It’s not commonly understood, even though the penalties can be pretty steep if you don’t prepare.
Let’s start there.
What is Accumulated Earnings Tax?
To answer the question of what an accumulated earnings tax is, we need to step back and talk for a minute about the unique tax situation of C Corporations.
Most small business owners and new business owners use the S Corporation or LLC (limited liability company) that has elected to be taxed as an S Corporation. This is a flow through entity. In other words, the income or loss from the business flows through to the shareholders.
As an example, let’s say you and your partner own an S Corporation 50/50. You both take a reasonable salary from the business and when that is subtracted, along with all other business deductions, the business has income. That income is reported on your and your partner’s tax returns. You each pay tax on your share of it.
Now let’s say you and your partner own a C Corporation 50/50. You both take a reasonable salary and when that and other deductions are subtracted, just like with the S Corp, there is income. In this case, though, the C Corporation pays the tax on that income. As a C Corp shareholder, you only have tax if you receive a salary or dividends. The income or loss from the C Corporation doesn’t impact the owners’ tax returns.
Currently, the C Corporation has a flat tax of 21% (federal). If your personal federal tax bracket is higher than that, the C Corporation might be a better strategy for you. You move income and the tax on that income from your higher tax bracket to the C Corporation.
Don’t jump into a C Corporation without some planning, though.
The income that the C Corporation retains will build up as equity in the company. This is known as Retained Earnings or Accumulated Earnings. The IRS allows C Corps to build up some Retained Earnings/Accumulated Earnings but over that amount, you need to be able to show a reason why. You need to be able to show you have a plan for the excess Accumulated Earnings.
The IRS limits are $250,000 for a ‘regular’ C Corporation and $150,000 for a professional service company.
If you have Accumulated earnings over that threshold ($150,000 or $250,000) be prepared for the IRS to ask you why you need the money. If you don’t have the right answer, you’ll pay have to pay a 20% penalty on the amount over the threshold.
Documentation for Accumulate Earnings In Your C Corporation
The IRS allows you to accumulate earnings if you need the cash flow due to seasonality of your business or due to growth in your industry. Also, if you plan to expand your business or are expecting some kind of change in it (good or bad), you will want to have more funds at your disposal. Other valid reasons that the IRS has allowed are money to shore up or start a pension plan or to pay off debt.
Document your decision-making process that went into determining you needed to stockpile cash. Include a record of that decision process it as part of your annual minutes.
If the IRS asks why you are accumulating excess earnings, you want to be able to show that this was part of your overall business strategy.
Got a question on which is the best business structure for you? Or maybe you want to make sure you’ve set the plan up correctly and are running it properly.
Those are perfect discussion questions for the Wednesday Coaching sessions. You can start and stop the Wednesday Coaching whenever you want. When you join, you get immediate access to the past 3 months’ worth of Home Study Courses and recordings of past sessions. Sessions are held live on the 1st – 4th Wednesday at 5 pm Pacific.