Accumulated Earnings Tax
An accumulated earnings tax is a tax imposed by the federal government on companies with retained earnings deemed to be unreasonable and in excess of what is considered ordinary. Corporations that accumulate their earnings or profits, instead of distributing them as dividends to shareholders, will be subjected to the accumulated earnings tax if the amount of earnings retained is above a certain level. An accumulated earnings tax is a tax imposed by the federal government on companies with retained earnings deemed to be unreasonable and in excess of what is considered ordinary. An accumulated earnings tax is a tax on retained earnings that are considered unreasonable, which should be paid out as dividends. If a company does not distribute any dividends by keeping a portion of retained earnings as accumulated earnings, shareholders are able to avoid this tax.
What Is an Accumulated Earnings Tax?
An accumulated earnings tax is a tax imposed by the federal government on companies with retained earnings deemed to be unreasonable and in excess of what is considered ordinary. Essentially, this tax encourages companies to issue dividends, rather than retain their earnings. The IRS allows for certain exemptions to the tax rule.
Understanding an Accumulated Earnings Tax
Corporations that accumulate their earnings or profits, instead of distributing them as dividends to shareholders, will be subjected to the accumulated earnings tax if the amount of earnings retained is above a certain level. These companies may accumulate earnings of up to $250,000 without incurring an accumulated earnings tax; any amount higher is deemed by the Internal Revenue Service as beyond the reasonable needs of the business. The accumulated tax rate is 20% of the accumulated earnings.
Reason for an Accumulated Earnings Tax
The government imposed the accumulated rate tax to deter shareholders from negatively influencing a company's decision to pay dividends and thereby avoiding having to pay taxes on dividends. If a company does not distribute any dividends by keeping a portion of retained earnings as accumulated earnings, shareholders are able to avoid this tax.
Companies that retain earnings typically experience higher stock price appreciation. Although this is beneficial to stockholders as capital gains taxes are lower than dividend taxes, it is detrimental to the government because tax revenues decrease. By adding an extra tax upon a firm's retained earnings, the government will either collect more taxes from the company or persuade them to issue dividends, thereby, allowing the government to collect from the shareholders.
Accumulated Earnings Tax Exemptions
A corporation has an exemption amount of $250,000. This means that a minimum accumulation earnings of $250,000 is allowed, and any amount that exceeds the exemption is taxed at 20%. For companies whose principal function is performing services in the fields of accounting, actuarial science, architecture, consulting, engineering, health, law, and the performing arts, the exemption amount is $150,000.
A corporation that has an accumulation of earnings may be liable to pay the accumulated earnings tax unless the business can show that the earnings over the threshold are for reasonable needs of the business, some of which the Internal Revenue Service (IRS) defines as:
Related terms:
Capital Gains Tax
A capital gains tax is a levy on the profit that an investor gains from the sale of an investment such as stock shares. Here's how to calculate it. read more
Dividend
A dividend is the distribution of some of a company's earnings to a class of its shareholders, as determined by the company's board of directors. read more
Dividend Payout Ratio
The dividend payout ratio is the measure of dividends paid out to shareholders relative to the company's net income. read more
Dividend Signaling
Dividend signaling suggests that a company announcement of an increase in dividend payouts is an indicator of its strong future prospects. read more
What Is the Internal Revenue Service (IRS)?
The Internal Revenue Service (IRS) is the U.S. federal agency that oversees the collection of taxes—primarily income taxes—and the enforcement of tax laws. read more
Retained Earnings
Retained earnings are a firm's cumulative net earnings or profit after accounting for dividends. They're also referred to as the earnings surplus. read more
Self-Employment
A self-employed individual does not work for a specific employer who pays them a consistent salary or wage. read more
Shareholder
A shareholder is any person, company, or institution that owns at least one share in a company. read more
Subvention Income
Subvention income is the amount of revenue that a not-for-profit organization is paid in order to cover the organization's annual operating expenses. read more