Plan Now to Escape the Corporate Retained Earnings Penalty

CHANTILLY, VA - A corporation that accumulates more than $250,000 in retained earnings could be slapped with a penalty "accumulated earnings tax" by the Internal Revenue Service (IRS), unless the retained earnings are handled very carefully. In general, the IRS limits corporations to stockpiling no more than $250,000 ($150,000 for personal service corporations) unless the money is being clearly retained for the "legitimate, reasonable future business needs of the business."

The reason for the penalty tax is to keep business owners from keeping earnings in their corporations so they don't have to pay taxes on the dividend distributions. How does the tax law define "reasonable"? There's no exact definition, but the IRS says that any plans for excess cash must be "specific, definite and feasible." Otherwise, your firm could face the accumulated earnings tax in addition to its regular corporate tax. The penalty is 15 percent.

The good news is that C corporations frequently fight the IRS on this issue - and win. For example, some businesses successfully put money aside to modernize their facilities or build new offices. In one case, a Texas corporation convinced the tax court that it needed excess earnings for several reasons, including renovation, expansion, and the possible redemption of shareholder stock. The firm wisely documented discussions of its plans and the court noted that officers exercised "prudent business judgment." (Knight Furniture Co., Inc. TC Memo 2001-19)

The key to beating the IRS is to establish a plan based on the reasonable, legitimate future needs of your business. Make sure to discuss the issue with your tax adviser, and document the plans in your corporate minutes.