The June 2018 Penn Wharton Budget Model survey indicated that over 235,000 business owners are projected to convert their pass-through businesses to C corporations.  Their primary motivation is to take advantage of the new 21% corporate tax rate under the 2018 Tax Cuts and Jobs Act.  This is particularly important for business owners who can’t fully benefit from the new Qualified Business Income deduction. In fact, the biggest switchers are owners of specified service businesses whose taxable income exceeds $415,000 for married filing jointly filers.

Although the new 21% rate is tempting, C corporations are subject to double taxation. Corporate income is taxed once at the entity level and again when it is distributed to shareholders as dividends. This can be avoided if the corporation retains all of it’s profits to finance growth.  However, this opens the door to the Accumulated Earnings Tax (AET) if profits accumulate beyond the reasonable needs of the business.

The AET is a penalty tax imposed on corporations for unreasonably accumulating earnings. The tax rate on accumulated earnings is 20%, the maximum rate at which they would be taxed if distributed.  The tax is in addition to the regular corporate income tax and is assessed by the IRS, typically during an IRS audit. There is no IRS form for reporting the AET. If imposed, the earnings are subject to triple taxation when eventually distributed to the shareholders. Once at the entity level, then when the AET is imposed and finally when the accumulated earnings are distributed to shareholders.

The AET applies when there is intent to avoid income tax at the shareholder level by accumulating earnings in the corporation. The AET applies even when tax avoidance is not the main reason for the accumulation of income but is only one of several reasons.  Keep in mind the IRS allows for an accumulated earnings credit of $250.000 or $150,000 if you are taxed as a Personal Service Corporation. Therefore, once your retained earnings exceed those limits you need to be concerned about the AET and document why your corporation needs accumulated earnings exceeding that amount.

The fact that a corporation is a holding or investment company is automatically considered evidence of the existence of a tax avoidance purpose unless the corporation can establish it wasn’t formed to avoid tax. A holding company is a corporation in which there is practically no activity other than the holding of investment property. An investment company is one that buys and sells stock, securities, real estate, and other investment property, in addition to holding investment property. If the corporation is not a holding or investment company, a tax avoidance motive is considered present if the corporation has accumulated earnings and profits in excess of the reasonable needs of the business unless it can prove otherwise by a preponderance of the evidence. The IRS regulations identify the following situations that may indicate accumulations beyond the reasonable needs of the business exist:

1. Loans to shareholders or related parties.
2. Payments by the corporation that personally benefit the shareholders.
3. Investments in assets having no reasonable relationship to the corporation’s business.
4. A weak dividend history.
5. Retention of earnings to provide against unrealistic hazards.
6. Working capital levels that appear high in relation to the needs of the business.

7. Salaries paid to shareholder/employees that are either extremely high (avoiding corporate  

     income tax) or extremely low (avoiding shareholder income and employment tax).

The AET is not assessed if accumulated earnings are reasonable in light of business needs. This subjective test can be satisfied by a variety of business reasons including retaining earnings to satisfy the reasonably anticipated future needs of the business.  The IRS regulations provide some broad criteria that can be used to justify that earnings are being accumulated for reasonable business needs. These include:

1. Providing for a business expansion or plant replacement.
2. Acquiring a business enterprise through purchasing stock or assets.
3. Facilitating the retirement of company debt created in connection with its trade or business.
4. Providing necessary working capital for the business.
5. Providing for investments in suppliers, or loans to customers or suppliers to maintain the business of the corporation.

6. Providing for contingencies such as the payment of reasonably anticipated losses such as an

    actual or potential lawsuit, loss of a major customer, or self-insurance.

The accumulated amount does not have to be used immediately or within a short period after the close of the tax year, so long as it will be used within a reasonable time depending on all the facts and circumstances relating to the future needs of the business.   

To avoid the AET which is 20% of “accumulated taxable income”, a corporation must be able to demonstrate to the IRS that its accumulations are necessary to meet its business needs. The corporation must have sufficient facts and documentation to substantiate that the plans for present and future business needs require additional funds. A determination of whether the accumulation of earnings and profits is a reasonable business need is based on the facts and circumstances of each case. 

The dramatic reduction in the corporate tax rate from 35% to 21% has sparked renewed interest in the AET. Although it remains to be seen whether flow-through entities will rush to covert to C corporations, those that do will need to pay attention to this tax.  Conversion may be the way to go if owners have no need for distributions and the corporation avoids the AET by proving its accumulations are for the reasonable needs of the business.

If you have any questions, please call Gregory J. Spadea at 610-521-0604.

Seven Year-End Tax Tips for 2018

Here are 7 tax moves for you to consider before the end of the year.

1. Defer income to next year. Consider opportunities to defer income to 2019, particularly if you think you may be in a lower tax bracket then. For example, you may be able to defer a year-end bonus or delay the collection of business debts, rents, and payments for services. Doing so may enable you to postpone payment of tax on the income until next year.

2. Accelerate deductions and take capital losses. You might also look for opportunities to accelerate deductions into the current tax year. If you itemize deductions, paying  medical expenses, mortgage interest, and charitable deductions before the end of the year, instead of paying them in early 2019, could make a difference on your 2018 return.

3. Harvest Capital Gains and Losses. Any appreciated stocks that you have held for a year and a day you can lock in the lower capital gains rate by selling at year end.   You should also consider selling any stocks that can generate capital losses which you can deduct up to $3,000 after netting all your capital losses against all your capital gains.  Keep in mind after you sell a stock you can buy it back after 31 days to avoid the wash sale rules.

4. Maximize retirement contributions. Deductible contributions to a traditional IRA, SIMPLE IRA or SEP IRA or pre-tax contributions to an employer-sponsored retirement plan such as a 401(k), can reduce your 2018 taxable income. If you haven’t already contributed up to the maximum amount allowed, consider doing so by year-end.

5. Take any required minimum distributions. Once you reach age 70½, you generally must

start taking required minimum distributions (RMDs) from traditional IRAs and employer-sponsored retirement plans. However an exception may apply if you’re still working for the employer sponsoring the plan). Take any distributions by the date required — the end of

the year for most individuals. The penalty for failing to do so is substantial: 50% of any

amount that you failed to distribute as required.

6. Beware of the 3.8% net investment income tax. This additional tax may apply to some or all of your net investment income if your modified adjusted gross income (AGI) exceeds $200,000 ($250,000 if married filing jointly, $125,000 if married filing separately, $200,000 if head of household).

7. Bump up withholding if you expect to owe tax. If it looks as though you’re going to owe federal income tax for the year, especially if you think you may be subject to an estimated tax penalty, consider asking your employer to increase your withholding for the remainder

of the year to cover the shortfall.  The biggest advantage in doing so is that withholding is

considered as having been paid evenly through the year instead of when the dollars are actually

taken from your paycheck. This strategy can also be used to make up for low or missing

quarterly estimated tax payments. With all the recent tax changes, it may be especially

important to review your withholding for 2018.

If you have any questions or need any help preparing your taxes please call Gregory J. Spadea at 610-521-0604.  The Law Offices of Spadea & Associates, LLC prepares tax returns and advises business and individual clients on estate and tax planning year round.