20.3 Accumulated Earnings Tax
Key Takeaways
The accumulated earnings tax (AET, §531) is a 20% penalty tax on improper accumulations.
Applies when corporations retain earnings beyond reasonable business needs to avoid dividend tax.
Accumulated earnings credit: $250,000 for regular corps, $150,000 for personal service corporations.
These credit amounts have never been inflation-adjusted since 1981 and are not changed by OBBBA.
Reasonable needs include expansion, working capital, debt retirement, and bona fide acquisitions.
Burden of proof shifts to the corporation once accumulations exceed the credit amount.
Accumulated Earnings Tax (AET — §531)
Why This Matters for the Exam
The AET is a trap for corporations that retain too much earnings. The exam tests the 20% rate, the $250K/$150K credit, and what constitutes reasonable business needs. OBBBA did not change AET — the figures below are the same for 2025 as in prior years.
What Is the AET?
The accumulated earnings tax (Internal Revenue Code §531) 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 (§535) |
| Purpose | Prevent tax avoidance |
| In addition to | Regular 21% corporate tax |
The Tax Avoidance Scheme AET Targets
Without AET, shareholders could:
| Step | Effect |
|---|---|
| 1. Retain earnings | Pay only 21% corporate tax |
| 2. Never pay dividends | Avoid 0-20% qualified dividend tax |
| 3. Sell stock later | Pay only 0-20% capital gains tax |
Result: Avoid the dividend tax entirely. AET prevents this by imposing a 20% surcharge on improper accumulations.
Accumulated Earnings Credit (Tax Year 2025)
Corporations can retain a minimum amount without AET risk:
| Corporation Type | Credit Amount |
|---|---|
| Regular C corporation | $250,000 |
| Personal service corporation (PSC) | $150,000 |
Note: These amounts have never been inflation-adjusted since 1981 and are unchanged by OBBBA.
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 |
| §303 redemptions to pay estate taxes |
Calculating Accumulated Taxable Income (§535)
| Start With | Adjustment |
|---|---|
| Taxable income | Starting point |
| - Federal income taxes | Deduct |
| - Charitable contributions (over 10% TI cap) | 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 |
|---|---|
| ≤ Credit amount | IRS must prove tax avoidance |
| > Credit amount | Corporation must prove reasonable needs |
AET Calculation Example (TY 2025)
| Item | Amount |
|---|---|
| Taxable income | $600,000 |
| Federal taxes paid (21%) | ($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 |
Personal Holding Company (PHC) Tax — §541 (Compare)
AET should not be confused with the related PHC tax (§541): also 20%, but mechanical (no business-purpose defense). PHC applies when both apply: (1) 60%+ of adjusted ordinary gross income is PHC income (passive — dividends, interest, royalties, rents, etc.), AND (2) 50%+ of stock is owned by five or fewer individuals at any time during the last half of the tax year. PHC tax is on undistributed PHC income at 20%.
Real-World Scenario
Scenario: A corporation with $500,000 accumulated E&P pays no dividends in 2025. The IRS asserts the accumulation is to avoid dividend tax.
- Burden: Because $500,000 > $250,000 credit, corporation must prove reasonable business needs.
- Documentation needed: Board minutes, expansion plans, working capital analysis.
- If no proof: 20% AET applies on excess over $250,000.
On the Exam
Question types to practice on AET:
- Rate Questions: "What is the AET rate?" (20%)
- Credit Questions: "What is the accumulated earnings credit?" ($250K regular / $150K PSC)
- Reasonable Needs Questions: "Which is a reasonable business need?"
- PHC vs AET Questions: Distinguish the two 20% penalties.
The key is to remember: 20% AET. Credit = $250,000 (regular) / $150,000 (PSC). Document reasonable business needs. PHC = mechanical 60%/50% test; AET = motive test.
What is the accumulated earnings tax rate?
15%
20%
21%
37%
What is the accumulated earnings credit for a regular C corporation?
$150,000
$200,000
$250,000
$500,000
Which is a reasonable business need for accumulating earnings?
Lending to shareholders
Investing in unrelated stocks
Funding business expansion
Avoiding dividend taxation
Which 20% penalty tax applies when 60%+ of a corporation's adjusted ordinary gross income is passive (dividends, interest, royalties, etc.) AND 50%+ of stock is owned by five or fewer individuals?
Accumulated Earnings Tax (§531)
Personal Holding Company Tax (§541)
Corporate Alternative Minimum Tax
Net Investment Income Tax
Sections you finish are checked off in the contents.