The accumulated earnings tax (AET) is a penalty imposed by the IRS on corporations for keeping earnings for longer than they need to run their businesses rather than paying out dividends to shareholders. The goal of the tax is to discourage corporations from accumulating excessive funds to avoid shareholder-level taxes. Corporations can avoid being exposed to this tax by paying out dividends, putting money back into the business to grow, and documenting reasonable business needs.
Key Takeaways
- The purpose of the tax is to discourage the accumulation of profits solely to avoid the tax on dividends.
- Taxpayers are never expected to self-impose the AET.
- The AET rate is 20% and is in addition to regular corporate income tax.
- Tax-exempt corporations are also exempt from the AET, such as personal holding companies and passive foreign investment companies.
How To Avoid Accumulated Earnings Tax
- Pay dividends: Give out dividends regularly instead of saving up earnings. By giving profits to shareholders, a company lowers its accumulated earnings and lowers the chance that it will have to pay AET.
- Document reasonable business needs: If you maintain proper business records to support the needs for accumulating earnings, you can likely dodge the AET bullet. This includes financial projections, business plans, and proof of growth, research and development, the need for working capital, or other good reasons to keep earnings.
- Monitor the retained earnings threshold: Keep accumulated earnings below the safe harbor threshold—this means that corporations can accumulate up to a certain amount of earnings without having to show reasonable cause or being exposed to the AET. Generally, there is a $250,000 AET safe harbor for corporations and a $150,000 safe harbor for certain service corporations, such as those that fall in the following industries:
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- Accounting
- Law
- Engineering
- Health
- Architecture
- Consulting
Allowable Reasons to Accumulate Earnings
The current tax rate on accumulated earnings is 20%. If you are worried about being exposed to the AET, the good news is that the IRS does not expect you to calculate the tax yourself on your tax return because it is a penalty tax assessed by the IRS for unnecessarily retaining earnings.
When calculating the penalty, the IRS considers the factors listed below. There are several allowable reasons for corporations to accumulate earnings beyond their accumulated earnings safe harbor, thereby avoiding the AET:
- Business development: If the corporation can show that it needs to save money to fund future business growth, like buying new assets or expanding into new markets, that could be seen as a good reason to save money.
- Working capital: A good reason to accumulate money is so that the corporation has enough working capital to pay for things like inventory, payroll, and other short-term responsibilities.
- Business emergencies: Accumulated earnings needed to deal with unplanned business emergencies or contingencies like equipment replacement or repairs can help a company avoid the AET.
- Research and development: A corporation’s earnings may be excluded from the AET if it can show that these activities are essential to its business development.
Frequently Asked Questions (FAQs)
No, the accumulated earnings tax does not apply to pass-through companies like S corporations.
Yes, a corporation can apply for an exemption from accumulated earnings tax by showing the IRS that the accumulated earnings are fairly needed for the business purposes of the corporation.
Bottom Line
The AET is a penalty imposed by the IRS on corporations that accumulate earnings beyond what is considered reasonable. The AET rate is currently 20% of the accumulated earnings and is in addition to income tax. To escape the AET, ensure that the earnings you accumulate are reasonable and necessary for your business.
