Accumulated Earnings Tax

[Corduroy Frog]

Client has been a government contractor, a C Corp with a single shareholder. Over last four years, has turned in some $1MM in profits. Corporation had a line of credit to offset the capital investment in contractural start-ups and lag in government billing turnaround. Last fiscal year, the corporation had untapped Retained Earnings of $750,000, but did not have a significant current ratio nor an overwhelming debt-to-worth ratio.

Corporation had prospered in a niche market in an infrastructure market. Without discussing sensitive information, suffice it to say the Iraq war, both from a funding standpoint and also logistics, collapsed this market. As contracts expired, the cash lag "caught up," plus the corporation in later stages of these contracts has squeezed out another $250K in profits.

Corporation now sits on a cool $1MM in retained earnings, and is awash in cash. Only $300,000 remain in receivables, with zero debt, only minimal liabilities. Today the current ratio and debt-to-worth ratio would be the envy of any company. I fear my client could now be an easy target for accumulated earnings tax.

If we appropriate some of these retained earnings, we must have a realistic basis.

100% shareholder has a remarkable track record of not commingling business with personal expenditures. He should not have to continue to maintain an operation just to lose money with operational loss. C Corp has never paid a dividend. He would be better off selling the corporation at 15% capital gains, then starting anew. The math works better this way than paying himself a taxable salary, or declaring taxable dividends.

I am asking for suggestions to avoid the Accumulated Earnings Tax. I don't think anyone voluntarily pays this, but occasionally the IRS will find a company they feel have purposely allowed too much equity to accumulate.

Anyone care to make suggestions? Thanks in Advance -- Corduroy Frog

[Roland Slugg]

In response for your request for suggestions

Dear Corduroy Frog

1) Declare and pay dividends. As long as that 15% federal tax rate remains in effect, the hit won't be too bad. In fact, it's an opportunity to get money out of a corp at a relatively modest tax cost.

2) Document uses for any remaining accumulation in excess of the exemption of $250k. Don't overlook, as a justification, the possible need of funds to pay death taxes.

I'm completely unaware of how aggressively the IRS targets the AE tax, or if it has a stated policy regarding what level of RE it will allow before getting interested. I do believe it's well above the statutory exemption of $250k ($150k for personal service corps), but how much above, I really can't say. If someone else has insight into this, I'd appreciate knowing.

[Corduroy Frog]

Roland

...thanks so much for your usual keen insight.

I have a problem with the 15% dividends -- do dividends from a small, non-publicly traded corporation (i.e. stocks are not really securities), qualify for the 15% treatment?

Thanks, C Frog

[Roland Slugg]

Yep

Do dividends from a small, non-publicly traded corporation qualify for the 15% treatment?

Absolutely! As long as the shareholder meets the 61/121 day rule, the dividends will be "qualified" dividends.

[Corduroy Frog]

Anyone Else?

Roland, thanks greatly for your comments. The estate tax thing was really helpful as I had no idea you could use something personal for a defense.

Anyone else wanna give this topic a try? I'm meeting with my customer next week on this very topic. There seems to be not a lot of information, as this is one of those "subjective" things. Maybe court cases??

[KJ Judd]

I treated them as qualified dividends when one of my few C corps. paid out dividends to the sole shareholder. You can check the 1099-DIV instructions. Maybe something there.