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From time to time, we receive calls asking about the accumulated earnings tax (AET). Many of our readers’ clients are small business owners organized as C corporations and the AET is a concern, particularly when doing business succession planning using a stock redemption agreement.

The AET is a penalty tax; it applies to corporations that accumulate “unreasonable” amounts of earned income inside the corporation rather than paying it out as salary, bonuses, or dividends. Why would a corporation accumulate earnings rather than pay them out? One reason could be that salary, bonuses, or dividends paid to an owner might be taxed at a rate as high as 39.6% on the owner’s personal tax return. On the other hand, earnings retained inside the corporation might be subject to a much lower tax bracket, or perhaps no tax at all if the corporation has “write-offs.”

The AET rate is 39.6%, and is in addition to the regular corporate tax rate. It’s no mere coincidence that the AET penalty tax (39.6%) is equal to the highest individual tax bracket.

In calculating the tax, there is an accumulated earnings tax credit of $250,000 ($150,000 in the case of certain personal service corporations). This means any corporation can accumulate that amount of retained earnings without concern for AET. Next, the tax applies only to amounts in excess of the credit that are not needed for “reasonable business needs.”

Many of our callers are under the misunderstanding that any amount of retained earnings in excess of the applicable credit is always subject to the penalty tax and miss the distinction that the penalty does not apply to accumulations needed for reasonable business purposes. A recent Tax Court Memorandum decision, Knight Furniture Co. v. Comm., TC Memo 2001-19, points out the importance of this distinction.

For tax years 1995, 1996, and 1997, Knight Furniture Company retained earnings and profits of, respectively, $6.4 million, $6.6 million, and $6.8 million. IRS sought to impose AET, and the taxpayer went to Tax Court.

In holding that the accumulation of earnings and profits was “reasonable,” the court looked at two sets of factors. First, in 1994, Knight Furniture was sued in a class action lawsuit involving credit life insurance purchased by customers buying furniture on installment. The corporation's commercial liability insurance would not provide coverage for any judgement entered. Although it was not estimated, it was thought the company’s potential liability could be large. The plaintiffs voluntarily dropped the suit in 1995, but were not prevented from reinstating it later.

A second set of important circumstances was the ownership of the company. Knight Furniture was started by two brothers, and the ownership passed into two families. Members of the Knight family owned approximately 55% of the company, and members of the Pedigo family owned approximately 45% of the company. It turned out there was “bad blood” between the two families and there was a strong possibility that at some time, the company would have to exercise a stock redemption program to buy out the members of one of the families in order to continue to exist. It was estimated it would take several million dollars to redeem the stock of one of the families.

The Tax Court ruled in favor of the taxpayer, holding that it had not retained earnings in excess of reasonable business needs. The Court stated the AET should not be imposed unless the accumulation of earnings and profits was clearly unreasonable and based upon tax motivation rather than business purposes.

The court said that it is a reasonable business purpose to accumulate earnings for the purpose of paying attorneys fees and potential damages not covered by liability insurance.

The court also held that accumulating earnings for the purpose of redeeming stock of shareholders is a reasonable business need where it’s necessary to guarantee the existence of the business or promote harmony in the operation of the business. Even though the business might otherwise finance the stock redemption using notes, borrowing money, or other financing means, accumulation of earnings and profits is not precluded as a legitimate strategy. The officers of the corporation acted prudently in preparing for a possible stock redemption by accumulating earnings and profits.

This case is good news, and should be filed for reference in case a client or client’s CPA objects to the accumulation of large amounts of cash value in corporately owned life policies held for the purpose of funding a stock redemption buy-sell agreement for fear of the AET.

Printed with permission from Advanced Underwriting Consultants

Last Updated: 12/15/2002 11:52:00 AM