In general, profits that have
not been distributed to shareholders are called retained earnings. A
corporation is permitted to accumulate earnings for use in expansion or
for other bona fide business reasons. However, if a corporation
accumulates earnings beyond reasonable needs of the business, it may be
subject to an accumulated earnings tax [IRC §531§537]. The
accumulated earnings tax is in addition to the income tax of a
corporation.
Retained earnings of $250,000 or less
($150,000 or less for personal service corporations) are considered within
the reasonable needs of a business. If a corporation accumulates over
$250,000 ($150,000 for personal service corporations) without making
distributions to its stockholders, it must have a bona fide business
reason for doing so. The corporation must be able to show that tax
avoidance is not one of the purposes of accumulation. Existence of a tax
avoidance purpose will trigger the accumulated earnings tax.
Note: There
is no line on the tax return to report the accumulated earnings tax. It is
a penalty tax applied after an IRS audit determines the corporation is
liable.
Reasonable Business Needs
The regulations under Section 537 provide
an analysis of reasonable needs of a corporation. This is not an exclusive
list.
Expansion: A
corporation can accumulate earnings to provide for bona fide expansion of
the business. This includes purchase of new buildings, equipment, or
machinery, either to replace old assets or to expand business operations;
and the acquisition of another business enterprise by purchasing its stock
or assets.
Pay Off Debts: Accumulated
earnings may be used to pay off debt created in connection with business
operations.
Product Liability Loss Reserves: A
corporation can accumulate earnings in anticipation of product liability
losses.
Section 303 Redemption Needs: A
corporation can accumulate earnings in anticipation of a need to redeem
stock of a shareholder who has died.
Supplier Or Customer Needs: A
corporation can accumulate earnings to provide for investments or loans to
suppliers or customers if necessary to maintain the business of the
corporation.
Working Capital: Accumulated
earnings may be used to provide a level of necessary working capital for
business operations. For example, assume that a supermarket needs
$4,000,000 of inventory on hand to operate. The corporation can obtain the
inventory by accumulating its earnings.
Unreasonable Needs
The following are considered unreasonable
needs of the corporation. This is not an exclusive list.
To avoid tax on dividend distributions.
To provide loans to shareholders.
To pay expenses for personal benefit of the shareholders.
To provide loans that have no reasonable relation to the conduct of
the business.
To provide loans to other corporations that are owned directly or
indirectly by the corporation or its shareholders.
To provide funds for investments which are unrelated to the activities
of the business.
To provide for unrealistic hazards.
"Bardahl Formula"
A method commonly used to substantiate
reasonable accumulation of earnings by a business is called the
"Bardahl Formula." The IRS assessed accumulated earnings tax on
Bardahl Manufacturing Corporation. Tax Court held that accumulation of
earnings by Bardahl was not unreasonable, and accepted the companys
stated method of computing necessary operating capital. The formula
calculates the amount needed to fund inventory by analyzing the average
number of days in an operating cycle, average inventory, average accounts
receivable, average accounts payable, and then comparing the current
working capital needs with actual accumulations of earnings.
Appropriated Retained Earnings Account
In order to avoid the accumulated earnings
tax, the corporate board of directors must discuss the need to accumulate
earnings, and the discussion must be reflected in the corporate minutes.
The financial statements of the corporation should also reflect the need
to accumulate earnings, so the shareholders know that the appropriated
amounts are not available for dividends. Corporations commonly accomplish
this by setting up an Appropriated Retained Earnings Account.
