The IRS recently issued guidance applying the accumulated earnings tax, a rarely imposed penalty that could take on increased importance if the tax rates proposed by the Republican “Blueprint” for tax reform are enacted.
The accumulated earnings tax is a 20% surcharge on the taxable income of a corporation formed or availed of for the purpose of avoiding shareholder taxes by permitting corporate earnings to accumulate rather than being distributed. As discussed below, the significance of the accumulated earnings tax was diminished in the 1980s when individual tax rates were lowered so as to align more closely with corporate rates, reducing the incentive to defer taxation at individual rates. This incentive could return under Blueprint-based reform, as the amount by which individual rates exceed corporate rates could increase.
In Chief Counsel Advice 201653017, the IRS considered the application of the accumulated earnings tax to a corporation that was formed to hold its sole shareholder’s non-controlling interests in eight investment partnerships. The corporation had no employees and conducted no activities other than in its role as a holding company. It had retained earnings and made no distributions to its shareholder.
The IRS considered whether the corporation had the necessary tax avoidance purpose under the evidentiary rules that guide such determinations for purposes of the accumulated earnings tax. These rules include a rebuttable presumption that a corporation that has accumulated earnings beyond its reasonable needs has done so for a tax avoidance purpose, and they provide that a corporation’s status as a holding company or an investment company is prima facie evidence of such a purpose. The IRS generally bears the burden of establishing that a corporation’s accumulation of earnings exceeds its reasonable needs.
In the advice memorandum, the IRS determined that, because the corporation was a holding or investment company, there was prima facie evidence that it was formed to permit its shareholder to avoid income tax and rejected the corporation’s position that it had been formed for the business purpose of preventing its shareholder from being subject to state and foreign taxes.
The IRS also rejected the corporation’s argument that it should not be subject to the accumulated earnings tax because it did not have cash to distribute to shareholders. Because the corporation’s taxable income is derived solely from the partnerships in which it holds non-controlling interests and the partnerships apparently did not distribute a significant portion of their earnings, the corporation had not in fact received (in cash or property) a significant portion of the earnings the IRS asserted it had abusively accumulated. However, the accumulated earnings tax is not based on a measure of liquid assets but rather taxable income, with statutory adjustments that do not include undistributed income of partnerships. Moreover, according to the IRS, the corporation and shareholder could and should have made use of provisions designed specifically to permit a corporation that has accumulated earnings beyond its reasonable needs but lacks liquidity to be treated as if it paid a dividend. Under the consent dividend procedures, a shareholder can agree to include in income a portion of a corporation’s earnings without actually receiving cash and such included amount will be treated as having been distributed by the corporation to the shareholder and then contributed by the shareholder to the capital of the corporation.
With the highest federal corporate and individual rates currently nearly equal at 35% and 39.6% (and most corporate distributions taxed at a maximum rate of 20%), it is not obvious the corporation in the advice memorandum was engaged in the rate arbitrage that was prevalent until the tax reforms of 1981 and 1986 reduced the highest marginal income tax rate for individuals from 70% to 50% and from 50% to 28%, respectively. Before these reductions, individual rates generally were significantly higher than corporate rates. As a result, individual shareholders often formed corporations to permit income to accumulate at lower corporate rates and avoid taxation at individual rates. Tax planning involving such an incorporation would typically occur only where the benefit of a rate differential was available to offset the cost of ultimately bearing two-levels of tax. However, with respect to existing corporations, the taxability of distributions will, and currently does, provide an incentive for the accumulation of earnings.
Although it’s too early to predict the tax rates that will apply if tax reform is enacted, it is possible the current tax reform effort could increase the incentive for tax-motivated incorporations and thus the relevance of the accumulated earnings tax. The Blueprint calls for a corporate tax rate of 20% and a highest individual rate of 33%, increasing the gap between the rates. And, because corporate distributions would continue to be taxable (at a maximum rate of 16.5%), the incentive for existing corporations to accumulate earnings would remain.