Key Takeaways
- The accumulated earnings tax (AET) is a 20% penalty tax.
- Applies when corporations retain earnings beyond reasonable business needs.
- Purpose: Prevent avoiding shareholder dividend taxation.
- Credit: $250,000 for regular corps, $150,000 for PSCs.
- Reasonable needs include expansion, working capital, debt retirement.
- Burden of proof shifts to corporation if over $250,000 accumulated.
Accumulated Earnings Tax (AET)
Why This Matters for the Exam
The AET is a trap for corporations that retain too much earnings. The exam tests the rate, the credit, and what constitutes reasonable business needs.
Expect at least 2-3 questions on AET.
What Is the AET?
The accumulated earnings tax is a 20% penalty tax on corporations that accumulate earnings beyond reasonable business needs to avoid shareholder dividend taxation.
| AET Element | Detail |
|---|---|
| Rate | 20% |
| Applies to | Accumulated taxable income |
| Purpose | Prevent tax avoidance |
| In addition to | Regular 21% corporate tax |
The Tax Avoidance Scheme
Without AET, shareholders could:
| Step | Effect |
|---|---|
| 1. Retain earnings | Pay only 21% corporate tax |
| 2. Never pay dividends | Avoid 0-20% dividend tax |
| 3. Sell stock later | Pay only 0-20% capital gains |
Result: Avoid the 20% dividend tax entirely. AET prevents this.
Accumulated Earnings Credit
Corporations can retain a minimum amount without AET risk:
| Corporation Type | Credit Amount |
|---|---|
| Regular C corporation | $250,000 |
| Personal service corporation | $150,000 |
Note: These amounts have never been inflation-adjusted since 1981.
Reasonable Business Needs
Accumulating beyond the credit is permitted if for reasonable business needs:
| Acceptable Needs | Not Acceptable |
|---|---|
| Working capital requirements | Loans to shareholders |
| Business expansion | Personal investments |
| Acquiring another business | Vague expansion plans |
| Debt retirement | Avoiding dividend tax |
| Anticipated lawsuits | Stock investments unrelated to business |
| Stock redemption for estate taxes |
Calculating Accumulated Taxable Income
| Start With | Adjustment |
|---|---|
| Taxable income | Starting point |
| - Federal income taxes | Deduct |
| - Charitable contributions (over 10%) | Deduct excess allowed |
| - Accumulated earnings credit | Deduct ($250k or $150k) |
| - Dividends paid deduction | Deduct |
| = Accumulated taxable income | AET base |
Burden of Proof
| Accumulated E&P | Burden of Proof |
|---|---|
| ≤$250,000 | IRS must prove tax avoidance |
| >$250,000 | Corporation must prove reasonable needs |
AET Calculation Example
| Item | Amount |
|---|---|
| Taxable income | $600,000 |
| Federal taxes paid | ($126,000) |
| Net after taxes | $474,000 |
| Less: Dividends paid | ($50,000) |
| Less: AE Credit | ($250,000) |
| Accumulated taxable income | $174,000 |
| AET (20%) | $34,800 |
Real-World Scenario
Scenario: A corporation with $500,000 accumulated E&P pays no dividends. The IRS asserts the accumulation is to avoid dividend tax.
- Burden: Corporation must prove reasonable business needs.
- Documentation needed: Board minutes, expansion plans, working capital analysis.
- If no proof: AET applies at 20% on excess over $250,000.
On the Exam
Expect 2-3 questions on AET, typically:
- Rate Questions: "What is the AET rate?"
- Credit Questions: "What is the accumulated earnings credit?"
- Reasonable Needs Questions: "Which is a reasonable business need?"
The key is to remember: 20% AET. Credit = $250,000 (regular) / $150,000 (PSC). Document reasonable business needs.
What is the accumulated earnings tax rate?
What is the accumulated earnings credit for a regular C corporation?
Which is a reasonable business need for accumulating earnings?