Lesson 2.5.1 Penalty Taxes on Corporate Accumulations

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From the course by University of Illinois at Urbana-Champaign

Taxation of Business Entities I: Corporations

18 ratings

University of Illinois at Urbana-Champaign

Taxation of Business Entities I: Corporations

18 ratings

Course 3 of 5 in the Specialization U.S. Federal Taxation

This course provides an introduction to the U.S. federal income taxation of corporations and their shareholders. The course focuses on the relevant provisions of Subchapter C of the Internal Revenue Code, as well as related Treasury Regulations and judicial opinions, governing corporate formation, operations, distributions, and liquidation. Practical in-class study problems facilitate self-discovery of technical tax knowledge along with the development of a variety of professional skills and attitudes.

From the lesson

Module 2: Corporate Income Taxation

In this module, you will compare the tax formula for C corporations with the tax formula for individuals. Next, you will examine special tax deductions available only to corporations, such as the dividends received deduction, and the organizational expenditures deduction. You will learn how to calculate corporate income tax liability and compute the corporate Alternative Minimum Tax (AMT). This module will also discuss book-tax differences, and finally, it will discuss compliance procedures.

Lesson 2.5.1 Penalty Taxes on Corporate Accumulations4:12

Lesson 2.5.2 Related Corporations3:31

Meet the Instructors

Michael P Donohoe, PhD, CPA
Associate Professor of Accountancy and PwC Faculty Fellow
Department of Accountancy, Gies College of Business

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This lesson is divided into two parts.

First, you will learn about two penalty taxes imposed on corporations to restrict

the accumulation of income inside the firm, the accumulated earnings tax and

the personal holding company tax.

In the second part, you will learn about rules that deal specifically with

the computation of tax liability for related corporations.

The regular and alternative minimum taxes are augmented by two penalty taxes.

Specifically, the accumulated earnings tax and

the personal holding company tax prevent corporations and

their shareholders from circumventing the double taxation of dividends.

And the steeply progressive marginal tax rates historically applicable to

individual taxpayers.

Not withstanding the anti-tax avoidance objective of these taxes,

their overall economic effect has waned over time as the gap between individual

and corporate tax rates has narrowed.

Further, the rules underlying these provisions are complex and lengthy.

Thus, our focus will be relatively broad.

Let's examine each penalty tax in turn.

The accumulated earnings tax targets profitable corporations motivated by tax

avoidance to accumulate profits inside the firm.

That is, not distribute them to shareholders as dividends beyond

reasonable business needs.

In particular, Code Sections 531 to 537 impose a 20% tax on current

year corporate earnings accumulated without a reasonable business need.

What constitutes a reasonable business need?

Well, for starters, most corporations are allowed a $250,000 minimum credit.

Thus, they can safely accumulate $250,000 of earnings over time,

without incurring the penalty tax.

The statutes also make exceptions for accumulations due to working capital

needs, debt retirements, and certain contingencies, such as lawsuits.

Treasury regulations also offer extensive guidance on what are reasonable and

unreasonable earnings accumulations.

Ultimately, the burden of justifying reasonable business needs

is on the taxpayer, not the IRS.

Thus, the courts often defer to the judgement of corporate managers, so

long as business needs are documented in a business plan with economic substance.

The personal holding company tax,

the second penalty tax on corporate accumulations, was created to prevent

taxpayers from avoiding higher graduated individual tax rates by using so-called

incorporated pocketbooks, incorporated talents, and incorporated properties.

In the first situation, wealthy individuals transferred investments to

a corporation in exchange for its stock.

The individuals could then enjoy lower corporate tax rates, and

the dividends received deduction.

In incorporated talents, a highly compensated individual,

such as an actress, would form a wholly-owned corporation and

agree to work for the corporation at a small salary.

The corporation would then contract out the services of its owner-employee for

a large sum, with the majority of the income taxed at lower corporate rates.

The third situation is similar to the other two, but

involves investment property and leaseback agreements.

Code Section 541 penalizes these strategies by imposing

a 20% tax rate on the undistributed income of a personal holding company.

The idea is to incentivize the distribution of net profits to

shareholders by otherwise imposing an expensive tax

on top of the regular corporate tax.

The code does provide several rescue provisions to help

corporations avoid the tax through special dividend payments.

To avoid overlap,

personal holding companies are not subject to the accumulated earnings tax.

So what exactly is a personal holding company?

The definition in the code is fairly technical and multi-faceted.

In short, however, a personal holding company is a closely held corporation that

derives at least 60% of its ordinary income from dividends, rents,

capital gains, and certain forms of personal service income.

And more than 50% of the stock value is held by not more than 5 individuals.

Note that certain entities, such as life insurance companies and some banks,

are excluded from this definition.

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