This week, Joe Kristan (CPA & Shareholder, Roth & Company (Des Moines, Iowa); Editor, Tax Update Blog) uses a recent IRS ruling to discuss how the accumulated earnings tax on C corporations may take on increased importance in a reformed tax code emerging from the Trump Administration and the 115th Congress.
Living fossil tax bites cashless C corporation
The accumulated earnings tax on C corporations is one of the more obscure items in the tax law. Designed to force corporations to distribute earnings as taxable dividends, it rarely comes up even in tax nerd get-togethers. A few years ago some populist politicians talked of strengthening it to force corporations to pay more dividends as a perverse form of economic stimulus, but interest soon faded.
The new administration may make C corporations much more attractive and more popular. If so, this living fossil may again rise from obscurity to bite taxpayers and their advisors. That makes a legal memorandum recently released by the IRS timely.
How the AET works. Code Section 531 imposes a 20% tax on “Accumulated Taxable Income” (ATI). of a C corporation “formed or availed of” to avoid income tax to shareholders by failing to distribute income. ATI is taxable income for the year, adjusted to reflect ability to pay dividends. ATI is reduced by dividends actually paid and by the “accumulated earnings credit,” which one standard reference calls “the amount of earnings and profits retained to meet ‘the reasonable needs of the business.'”
While it is only computed on the “excess” income accumulated for a tax year, the IRS takes into account retained earnings from prior years in determining whether a business “needs” to accumulate current income. If a corporation is an operating company, rather than a mere investment or holding company,” the first $250,000 of lifetime earnings is exempt.
For example, assume a C corporation earns $1 million in 2016. It pays federal and state tax of $400,000 and no dividends, leaving it with $600,000 in undistributed income. It also is sitting on retained earnings of $4 million at the beginning of the year. The IRS determines that the reasonable needs of the business only require $2 million of retained earnings, so the entire $600,000 in accumulated 2015 income is “excessive,” and it imposes a 20% tax, or $120,000, on top of the 34% federal corporation tax already paid.
I have only seen one accumulated earnings tax case in person, in 30-odd years of tax practice, but IRS Legal Memorandum 201653017 shows that it still lurks. In the memo, an individual who apparently was a hedge fund manager placed some hedge fund partnership interests in a C corporation. Why? Apparently to try to avoid state income taxes. The funds didn’t generate much cash, but they did have K-1 taxable income, and the corporation had to pay income tax.
The corporation didn’t pay dividends. It also didn’t include accumulated earnings tax on its return. It would be hard to do, because unlike almost every other corporation tax, the AET isn’t self-assessed, and there is no form for taxpayers to compute and pay it.
That leaves it up to IRS examiners to assess it, and they did so here. The taxpayer protested that he couldn’t have excess accumulations because he didn’t have any cash to speak of. The IRS Chief Counsel’s Office said that didn’t matter:
Taxpayer seems to suggest that accumulated surplus must be represented by cash that is available for distribution. However, the Internal Revenue Code computes the accumulated earnings tax based on accumulated taxable income, and at least with respect to a mere holding company for which reasonable needs of a business are not relevant, it is not concerned with the liquid assets of the corporation.
So if it has no liquid assets, how is it supposed to pay a dividend?
Moreover, the consent dividend procedures provided by § 565 would have allowed Taxpayer and Shareholder to avoid the accumulated earnings tax irrespective of any lack of liquidity. The Service has considered a similar case previously. In TAM 9124001, the Service explicitly rejected the argument that a lack of liquidity excuses a taxpayer from the accumulated earnings tax.
Section 565 allows taxpayers to pretend to distribute a dividend, pay tax on it, and pretend to recontribute the pretend amount to corporation capital. For obvious reasons, this isn’t a popular move. Here the IRS says that it is the only way the taxpayer could have avoided the AET.
Back in my early career, when C corporations walked more of the earth than they do now, taxpayers documented “reasonable needs” of the business with corporate minutes mentioning future expansion plans, the lurking possibility of lawsuits, and other imagined possible reasons to not make dividend distributions. This is still a good idea.
As Tony Nitti has noted, the likelihood of significant corporate tax rate cuts and the availability of the Sec. 1202 exclusion on gains from the sale of original issue stock may make C corporations popular again. As long as the accumulated earnings tax lurks, though, the possibility of a second tax on corporation income will temper taxpayer enthusiasm.
Here’s the rest of this week’s Tax Roundup:
Tuesday, January 3, 2017
David Herzig, Budget Reconciliation Process and Obamacare (Surly Subgroup). “The problem for the republicans is the Byrd rule. Repeal of the ACA will have budgetary impact beyond the budget window.”
Jack Townsend, IRS Designates Syndications Exploiting Improper Valuations for Conservation Easement Deductions. “I note at a couple of places in the Federal Tax Procedure Book that some of the most abusive tax shelters do not fail because the legal positions are faulty. Rather, they fail because the legal positions are all based false facts, often a false valuation of property.”
Jason Dinesen, From the Archives: Taxpayer Identity Theft, Part 18. “This post from August 2013 is the next-to-last in a series of posts about a client of mine who spent more than 2 years — or 850 days, or 2 years, 3 months, 28 days — battling the IRS after her deceased husband’s identity was stolen.”
Jim Maule, When Tax Legislation Fails: Who Pays the Price? “The nation’s federal and state legislatures and executive departments are increasingly filled with people who think they know what they are doing but who have not much of a clue, and who generate more and more laws and regulations that don’t work, that cause hardship, and that fail to address the underlying problem.”
Joyce Russell, Iowa Shoppers Now Pay Sales Tax on Amazon (IPTV.org). There are still outfits that don’t collect sales tax. If the online vendor doesn’t charge Iowa sales tax, purchasers are supposed to pay the widely-ignored consumers use tax. If Iowa really wants to collect such use taxes, they should add a line to the 1040 enabling taxpayers to pay it with income taxes, rather than going through the clunky Iowa use-tax process.
Kay Bell, Top 10 tax topics of 2016 and what to expect in 2017. “When taxpayers who file early in 2017 expecting to have their refunds in hand by the end of the month discover that they’ll have to wait at least a couple more weeks, you’ll hear the complaining nationwide.”
Lew Taishoff, THIRTY DAYS HATH SEPTEMBER. “Sometimes the complexities found in the Glasshouse at 400 Second Street, NW, drive even the obvious from minds of the self-represented who enter there.”
News from the Profession. Accounting Firms That Aren’t Paperless Need to Get Their Act Together (Rachel Andujar, Going Concern)
Peter Reilly, IRS Denies Exempt Status To Scholarship Fund Targeted To Founder’s Child. “So here is an idea for a tax deductible college educations. Set up a scholarship fund with seemingly neutral criteria that by wild coincidence your kid and nobody else meets.”
Robert D. Flach comes through with the first Buzz! of 2017. Links cover the ground from prominent tax offenders to 2016 disaster relief, with an anti-tax software snarl thrown in at no extra charge!
Roger McEowen covers The Most Important Agricultural Law and Tax Developments of 2016.
Russ Fox, Start Your 2017 Mileage Log Now. “Each time you drive for business, note the date, the starting and ending mileage, where you went, and the business purpose.”
Ryan Foley, Donors to Iowa governor’s 2015 inaugural fund remain secret. The tax angle is that apparently the Form 990 for the organization omits donor information, apparently on the grounds that it has been lost. I am quoted as saying such omissions from 990s can trigger late filing penalties.
Scott Drenkard, Several States Will Start 2017 with Corporate Tax Reductions (Tax Policy Blog). North Carolina, Arizona, New Mexico, Indiana and D.C. all are cutting their corporation rate. Meanwhile, Iowa’s highest-in-the-nation 12% rate remains unchanged. Maybe 2017 will fix that.
TaxProf, The IRS Scandal, Day 1332, Day 1333, Day 1334, Day 1335
Wednesday, January 4, 2017
Anne McClean, Too good to be true – generally yes (TaxPlus). “This comes as new research by the FCA reveals a fifth (22%) of over 55s, with above average incomes, suspect they were targeted by a fraudulent investment scam in the past three years, rising to a third (32%) of those aged 75 and over.” This is in the UK, but it’s just as true here.
Jason Dinesen, From the Archives: Handling Franchise Fees on a Tax Return
Jeremy Scott, 2017 Could Be a Big Year for Tax Policy (Tax Analysts Blog). “Most obviously, the incoming Trump administration and its Republican allies in Congress would love to remake the U.S. tax code by repealing Obamacare (which has many important tax components) and passing a tax reform package that lowers rates and alters how business income is treated.
Jim Maule, Trying to Make Cents of Two More Coin Payment stories. “The mayor brought in 28 buckets filled with 360,000 nickels and pennies.”
Kay Bell, Free File 2017 opens for lucky filers on Friday, Jan. 13
Leslie Book, New York Times Article on Call Center Tax Scams Highlights How Criminals Prey on Our Citizens Fear of IRS. “The key to the success of the scam, according to the Indian teen call center employees, is the ‘psychological fact’ that some Americans deeply fear their government.” Hard to imagine why.
Lew Taishoff, CHENERY PLUS INTUITION? “Takeaway– Put in everything you’ve got at the very beginning.”
News from the Profession. EY Counts the Votes for the Golden Globes, You Guys (Caleb Newquist, Going Concern)
Renu Zaretsky, Why are Chicago homeowners leaving money on the table? (TaxVox).
Robert D. Flach, DON’T FORGET TO REMEMBER: “If you plan to contribute to a traditional or Roth IRA, a Coverdell Education Savings Account, a Section 529 College Savings Plan, a Health Savings Account, or an ABLE account for tax year 2017 do it today. People tend to ask about the last day for making such investments when they should be asking about the first day.
Robert Wood, IRS Escalates Hunt For Bitcoin Users In Coinbase Summons Case
Roger McEowen, Top Ten Agricultural Law and Tax Developments of 2016 (Ten Through Six). The proposed regulations to eliminate valuation deductions for family business interests comes in at number 8.
TaxGrrrl, The Top Tax Posts You Did – And Didn’t – Read In 2016. “Here are my best top tax posts, as determined by me, that you didn’t read in 2016…”
TaxProf, The IRS Scandal, Day 1336
Thursday, January 5, 2017
Annette Nellen, Repealing Obamacare – Costs and Issues!: “Repeal won’t be easy and likely won’t be popular.”
Career Corner. The Cubs are hiring! (Caleb Newquist, Going Concern). “Sure, it’s just an A/R position, but being a bat boy or girl for a game or two is probably one of the perks.”
David Herzig, Top 2017 Tax Twitter Follows. “Every year, Kelly Erb (@taxgirl) posts her top tax Twitter follows. This year, I was fortunate to make the list.” So was I. Follow me at @joebwan.
Kay Bell, Tax pros are target of new e-services phishing scam. “In its official email newsletter to tax professionals, the IRS warns that the latest fake emails may appear to be from the IRS or e-services.”
Keith Fogg, Verifying the Approval of the Immediate Supervisor As Required by IRC 6751 (Procedurally Taxing)
Lew Taishoff, A POST-HOLIDAY BARGAIN. “Although Judge Morrison didn’t mention it, Amnesty National had been in Tax Court twelve (count ‘em, twelve) years ago about a dubious refund claim that generated 2004 T. C. Memo. 221, filed 9/29/04, where Judge Chiechi likewise found irrelevant and incomprehensible arguments.”
Paul Neiffer, Don’t Delay on Form 1099s. “One of the changes to the tax rules is that Form 1099s this year are due both to the recipient and to the IRS by January 31, 2017.”
Robert D. Flach has A NEW GUIDE FOR SCHEDULE C FILERS. “This is an extensive “must-have” guide for the newly self-employed sole proprietor who will be reporting business income and expenses on Schedule C, and also a good source of information and advice for the already existing business.”
Robert Wood, IRS Forms 1099 Are Coming, Packing A Tax Punch: There’s a 1099-INT for interest; 1099-DIV for dividends; 1099-G for state and local tax refunds and unemployment benefits; 1099-R for pensions and payouts from your individual retirement accounts; 1099-B for broker transactions and barter exchanges; 1099-S for real estate transactions, etc. In fact, there’s a dizzying array. There are many categories, but the Form 1099-MISC (for miscellaneous) seems to prompt the most questions, and covers the biggest territory.
Scott Drenkard, Sports Drinks Are Now More Expensive than Beer Thanks to the Philadelphia Soda Tax (Tax Policy Blog). “On January 1st, the controversial Philadelphia soda tax took effect. It is levied at a rate of 1.5 cents per ounce, which is 24 times the tax levied on beer in the state of Pennsylvania.”
TaxGrrrl, Coinbase Customer Responds Anew To IRS Efforts To Identify Bitcoin Users
TaxProf, The IRS Scandal, Day 1337.