Question

During a recent IRS audit, the revenue agent decided that the Parker family used their closely held corporation, Falco, to avoid shareholder tax by accumulating earnings beyond the reasonable needs of the business. Falco’s taxable income was $900,000, it paid no dividends, and it had no business need to retain income. Falco’s marginal tax rate in prior years was 34 percent.

Required:

1. Compute Falco’s accumulated earnings tax assuming that it had accumulated $4 million after-tax income in prior years.
2. Compute Falco’s accumulated earnings tax assuming that it had accumulated $129,000 after-tax income in prior years.

Answer 1

As per IRS Publication 542, a corporation can accumulate its earnings for a possible expansion or other bona fide business reasons. However, if a corporation allows earnings to accumulate beyond the reasonable needs of the business, it may be subject to an accumulated earnings tax of 20%. Hence, if Falco has accumulated $4 million after-tax income in prior years, it will be liable for an accumulated earnings tax $4 million.as IRS Publication 542 provides that "To determine if the corporation is subject to this tax, first treat an accumulation of $250,000 or less generally as within the reasonable needs of most businesses. Treat an accumulation of $150,000 or less as within the reasonable needs of a business whose principal function is performing services in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and the performing arts."

Hence. in the first case, assuming that Falco is operating in business it will be subject to a tax @ 20% on 4 mn - 250,000 = 3.78 Mn * 20% = 750,000

Assuming that Falco is operating in other areas than business, it will be subject to a tax @ 20% on 4 mn - 150,000 = 3.85 Mn * 20% = 770,,000

However, if the accumulated earnings of Falco is $129,000 as in the second case, the accumulated earnings tax does not apply since the amount of the accumulated earnings of Falco is $129,000 which is well within both the limits of $250,000 and $150,000 under the above proviso. Hence, the accumulated earnings tax will not apply in the second case.