Updated: Feb 28, 2019
With a 21% tax, it is better than ever to be a C-corporation. This is especially true for those who do not qualify for the §199A election. Before you start electing all your entities to be treated as a C-corporation, there are 2 taxes you should be aware of: the Accumulated Earnings Tax and the Personal Holdings Company Penalty Tax. For a background on how Corporations are taxed, check out our Choice of Entity video.
Accumulated Earnings Tax ("AET")
Recall from our Choice of Entity video that owners are taxed once at the corporation's level and another when the corporate earnings are distributed. Theoretically, you could hold the earnings in the corporation until it is beneficial to distribute them. Thus, the two events can be spread out in multiple tax years.
For example, if you are in a specified service trade or business under §199A, the amount of deduction began to phase out when you reach 157,500/315,000 for MFJ taxpayers. Once you reach 207,500/415,000 MFJ, that deduction is completely phased out. With some planning you can shift the extra income to a corporation, where the income can accumulate. Once your AGI is lowered, you can then take out the income as distribution. Win-win?
Not so much. Under IRC §532, Congress places the AET on corporations that allows its earnings and profits to accumulate instead of being divided or distributed to its shareholders. The IRS assesses the AET when a corporation accumulates more than $250,000 ($150,000 if service business) without a valid business purpose. The AET places a 20% tax on a corporation's earnings deemed to exceed the corporation's ordinary and reasonable business needs.
So what can you do?
To be liable for the AET, the IRS must prove that your corporation intended to avoid the income tax on its stockholders by accumulating earnings and profits instead of distributing them. In other words, your corporation cannot justify a reasonable need for retaining the earnings and profits. One way is to come up with reasonable needs for holding onto the funds. An example can be holding the funds for an expansion.
However, you have to prove this. Show the IRS the budgeted amount, how much you plan on borrowing if at all, research you made into this expansion. In other words, do not lie. If you are truly expanding, make sure you can prove it.
You should also avoid the following:
Shareholder loans. The IRS views the loans as replacements for dividends. If there are patterns of shareholders taking out loans for personal reasons, then this shows that the corporation has capacity to distribute dividend, but chose not to to escape dividend level tax.
Unrelated investments. If your company makes widgets and extra funds are used to invest in available for sale securities, this might look at little fishy.
History of not paying. If your corporation has a history of not paying dividend, there is an indicator that the corporation is accumulating earnings to avoid shareholder taxes.
Should you have any questions on what you can and cannot do, reach out to us. We'll be happy to help.
Although the AET applies to both public and private C-Corps, in reality, the AET is mostly used on private corporations. This is because public corporations have hundreds of thousands of shareholders, which makes it nearly impossible for the IRS to prove that the corporation is being "formed or availed of" for a tax-avoidance purpose.
Personal Holdings Company ("PHC") Penalty Tax
Probably the more prominent of the two taxes is the penalty tax placed on PHCs. The IRS classifies a corporation as a PNC when (1) Five or fewer individuals own more than 50% of the value of the corporation’s stock at any time during the last half of the corporation’s tax year and (2) Passive income comprises at least 60% of the corporation’s gross income. This is common in closely held corporations.
Common Passive income includes: dividends, interest, royalties, annuities, rents, personal service income, and more. If in doubt, check with a tax professional (I happen to know one).
The PHC penalty tax is 20% of the undistributed PHC income. This applies after the corporate income tax of 21%. PHCs must file Schedule PH to calculate their PHC tax. The taxpayers attach Schedule PH to its corporation income tax return, Form 1120. If the schedule is not filed, the statute of limitations on the assessment of PHC tax is extended from the usual three years to six years. For example, a corporation with one owner earned $50,000 in interest income for the year and did not distribute any income. The $50,000 is subjected to a 21% corporation rate of $10,500 and $7,900 of PHC tax (20% after net income tax amount).
Certain types of corporations will not be considered a PHC. These include:
Banks, domestic building and loan associations, and certain lending or finance companies
Life insurance and surety companies
Certain small business investment companies operating under the Small Business Investment Act of 1958
Corporations under the jurisdiction of the court in a bankruptcy or similar case, and
So what can you do?
Increase the number of owners to disqualify the first test
Monitor your income to ensure 60% of the gross income is not passive income
Pay out dividends. The PHC tax is assessed on undistributed PHC income, a payment of a dividend will eliminate the tax.
Allow for consent dividend. A consent dividend is an amount the shareholders agree to report as dividends even though not received by them.
Hire a good tax attorney :)
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