Accumulated Earnings Tax Definition

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Accumulated Earnings Tax Definition

What Is an Accumulated Earnings Tax?

An accumulated profits tax is a federal government tax levied on businesses with retained earnings that are judged unjustified and in excess of what is considered usual. Essentially, this tax encourages businesses to pay out dividends rather than keep their profits. Certain exclusions to the tax rule are permitted by the IRS.

Key Takeaways

  • An accumulated earnings tax is a tax on unreasonably kept profits that should be distributed as dividends.
  • To prevent firms from failing to pay dividends to their shareholders, the government taxes accumulated profits.
  • Dividends are taxed more heavily than capital gains, hence it is financially advantageous for shareholders to avoid paying dividend taxes.
  • The rate of cumulative profits taxation is 20%.
  • Exemption levels of $250,000 and $150,000 are available, depending on the firm.
  • The IRS also grants exemptions depending on the necessity for the accumulated profits.

Understanding an Accumulated Earnings Tax

Corporations that keep their earnings or profits rather than releasing them as dividends to shareholders will be liable to the accumulated earnings tax if the amount of earnings held exceeds a specific threshold. These businesses may accrue profits of up to $250,000 without paying an accumulated earnings tax; any amount more is regarded by the Internal Revenue Service to be in excess of the business’s legitimate requirements. The cumulative tax rate is 20% of the total profits.

Reason for an Accumulated Earnings Tax

The cumulative rate tax was implemented by the government to discourage shareholders from adversely affecting a company’s choice to pay dividends and thereby avoiding having to pay dividend taxes. Shareholders may avoid this tax if a corporation does not issue dividends and instead keeps a part of retained profits as accumulated earnings.

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Companies that keep their profits tend to have stronger stock price appreciation. Although this benefits shareholders since capital gains taxes are lower than dividend taxes, it harms the government because tax revenues are reduced. By imposing an additional tax on a business’s retained profits, the government may either collect more taxes from the company or induce it to pay out dividends, enabling the government to collect from the shareholders.

Accumulated Earnings Tax Exemptions

The exemption amount for a company is $250,000. This implies that a minimum accumulation earnings of $250,000 are permitted, and any amount in excess of the exemption is taxed at a rate of 20%. The exemption level is $150,000 for organizations whose primary job is to provide services in the disciplines of accounting, actuarial science, architecture, consulting, engineering, health, law, and the performing arts.

A company with an accumulation of profits may be required to pay the accumulated earnings tax unless the firm can demonstrate that the earnings over the threshold are for legitimate business requirements, which the Internal Revenue Service (IRS) defines as:

  • “Specific, precise, and workable methods for using profits accumulated”
  • Where the accumulated sum is required for the payment of reasonably foreseeable product liability losses
  • Various redemption needs”

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