Business Entities · Corporations in general

Accumulated earnings tax

The accumulated earnings tax is aimed at a corporation that hoards profits to spare its shareholders the tax they would pay on a dividend. It is a penalty tax rather than a revenue measure — nobody plans to pay it, and its function is to make retention less attractive than distribution. The single most important thing about it is what it is imposed on, because the intuitive answer is wrong: it falls on one year’s undistributed income, not on the accumulated pile.

The rule

The imposition. 20 percent — in addition to the other taxes imposed by chapter 1, an accumulated earnings tax is imposed for each taxable year on the accumulated taxable income, as defined in IRC § 535, of each corporation described in IRC § 532, at that rate (IRC § 531)^TY2026

On what. accumulated taxable income means the taxable income for the year, adjusted as IRC § 535(b) provides, minus the sum of the dividends paid deduction under IRC § 561 and the accumulated earnings credit — so the tax falls on a single year's undistributed income, not on the accumulated balance of earnings and profits (IRC § 535(a))^TY2026

Which corporations. the tax applies to every corporation formed or availed of for the purpose of avoiding income tax with respect to its shareholders, or those of any other corporation, by permitting earnings and profits to accumulate instead of being divided or distributed — but not to a personal holding company, a corporation exempt under subchapter F, or a passive foreign investment company, and it applies regardless of the number of shareholders (IRC § 532)^TY2026

How the purpose is proved. the fact that earnings and profits are permitted to accumulate beyond the reasonable needs of the business is determinative of the purpose to avoid income tax with respect to shareholders unless the corporation proves the contrary by the preponderance of the evidence, and being a mere holding or investment company is prima facie evidence of that purpose (IRC § 533)^TY2026

The credit for the year. for a corporation other than a mere holding or investment company the accumulated earnings credit is the part of the year's earnings and profits retained for the reasonable needs of the business, less the IRC § 535(b)(6) deduction, the amount retained being the excess of the year's earnings and profits over the dividends paid deduction (IRC § 535(c)(1))^TY2026

And the floor beneath it. $250,000 — the credit is in no case less than the amount by which that figure exceeds the corporation's accumulated earnings and profits at the close of the preceding taxable year. For a corporation whose principal function is performing services in health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting the figure is $150,000. A mere holding or investment company gets only this minimum credit and nothing for reasonable needs (IRC § 535(c)(2), (3))^TY2026

What counts as a reasonable need. reasonable needs of the business includes the reasonably anticipated needs of the business, the IRC § 303 redemption needs of the business, and the excess business holdings redemption needs of the business (IRC § 537(a))^TY2026

And what earnings and profits are. a dividend is any distribution of property made by a corporation to its shareholders out of earnings and profits accumulated after 28 February 1913, or out of the earnings and profits of the taxable year computed as of the close of that year without diminution by reason of distributions made during it and without regard to the amount on hand when the distribution was made. Every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits (IRC § 316(a))^TY2026

Current figures

How it works in practice

Start with the base, because it is the thing most often got wrong. IRC § 531 imposes the tax on accumulated taxable income, which IRC § 535(a) defines as the year’s taxable income, adjusted, less the dividends paid deduction and less the accumulated earnings credit. It is a flow, not a stock. A corporation sitting on a very large balance of accumulated earnings and profits owes nothing in a year in which it earned nothing and distributed nothing, because there is no accumulated taxable income for that year. The tax reaches the act of retaining this year’s profits, not the fact of holding last year’s.

That also explains why the minimum credit is drafted as it is. IRC § 535(c)(2)(A) gives a credit of the amount by which the statutory figure exceeds accumulated earnings and profits at the close of the preceding year. So the minimum credit is a lifetime allowance being used up, not an annual one: a corporation whose accumulated earnings and profits already exceed the figure gets no minimum credit at all, and must justify the whole of the current year’s retention on reasonable needs.

The reasonable needs credit is the real defence and it is measured on the year, not on the balance. IRC § 535(c)(1) gives credit for so much of the year’s earnings and profits as are retained for the reasonable needs of the business, retained meaning the excess of the year’s earnings and profits over the dividends paid deduction. So a corporation with a genuine plan — an expansion, a plant, a known liability — shelters this year’s retention by reference to it.

Two categories of corporation are treated more harshly. A mere holding or investment company gets only the minimum credit under IRC § 535(c)(3), with no reasonable-needs credit at all, on the footing that such a company has no business whose needs could justify retention. And a corporation whose principal function is performing services in one of the eight listed fields has its minimum credit reduced. The list is closed — health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting — and a service business outside it takes the higher figure.

On proof, the burden structure is unusual and worth being precise about. IRC § 532(a) requires a purpose of avoiding shareholder-level tax. IRC § 533(a) then provides that accumulation beyond the reasonable needs of the business is determinative of that purpose unless the corporation proves the contrary by the preponderance of the evidence. So establishing unreasonable accumulation effectively establishes the purpose, and the corporation carries the burden of displacing it. For a mere holding or investment company, IRC § 533(b) makes that status prima facie evidence of the purpose without more.

The tax is not self-assessed. There is no line for it on the return; it arises on examination, and it is imposed “in addition to other taxes imposed by this chapter” (IRC § 531). That gives it a practical character quite unlike the rest of subchapter C — a corporation does not “file” accumulated earnings tax, it is assessed it — and it is why contemporaneous documentation of a retention plan matters so much more than the accounting treatment.

Scenarios

How this has changed

The rate is the item that has moved, and it moved for a structural reason rather than a policy one. The accumulated earnings tax has historically been set at or near the top individual rate on dividends, because its function is to make retention no cheaper than distribution. When qualified dividend income became taxable at capital gain rates, the accumulated earnings tax was aligned to the same figure, and the alignment has been maintained since. Material giving a graduated accumulated earnings tax, or a rate in the high thirties, is describing the position before that alignment.

The provisions themselves have been stable for decades. The statutory minimum credit figures have not been indexed and have not changed in a very long time — which means that in real terms the shelter they provide has eroded steadily, and a corporation of a size that would once have been comfortably inside the minimum credit may now exceed it many times over. That is not a change in the law, and no amendment note records it, but it is the reason the tax reaches further than it used to.

The exception for personal holding companies in IRC § 532(b)(1) reflects the fact that such a company faces its own penalty tax under a different part, and the two are mutually exclusive rather than cumulative.

Exam focus

The reliable question gives an accumulated balance and asks for the tax, and the trap is to apply the rate to the excess of that balance over the statutory figure. That is not the computation. The base is accumulated taxable income for the year — taxable income adjusted, less dividends paid, less the credit.

Where the question gives accumulated earnings and profits at the close of the prior year, use them to compute the minimum credit, which is the excess of the statutory figure over that balance and is nil once the balance exceeds it.

Read for whether the corporation is a mere holding or investment company, which loses the reasonable-needs credit entirely, and for whether it is in one of the eight listed service fields, which halves the minimum figure. Both are decided by short phrases in the facts.

Check yourself

1. A corporation has accumulated earnings and profits of $6,000,000 at the close of 2025 and has no taxable income in 2026. What is its accumulated earnings tax for 2026?

Answer: nil. IRC § 531 imposes the tax on accumulated taxable income as defined in IRC § 535(a), which begins with the taxable income for the year. With no taxable income there is no accumulated taxable income, whatever the size of the accumulated balance. The tax reaches this year’s retention, not last year’s holdings.

2. A manufacturing corporation had accumulated earnings and profits of $180,000 at the close of the preceding year. What is its minimum accumulated earnings credit for the current year?

Answer: the excess of $250,000 over $180,000, so $70,000. IRC § 535(c)(2)(A) sets the minimum credit as the amount by which the statutory figure exceeds accumulated earnings and profits at the close of the preceding taxable year. Had the balance been $260,000 the minimum credit would have been nil.

3. An architecture firm operating as a C corporation had accumulated earnings and profits of $90,000 at the close of the preceding year. What is its minimum credit?

Answer: $60,000. IRC § 535(c)(2)(B) substitutes $150,000 for $250,000 in the case of a corporation whose principal function is performing services in architecture, among the other listed fields, so the credit is the excess of $150,000 over the $90,000 balance.

4. A corporation holding only a securities portfolio retains its investment income and documents a plan to acquire an operating business. May it claim a reasonable-needs credit?

Answer: no. IRC § 535(c)(3) provides that for a mere holding or investment company the accumulated earnings credit is only the amount by which the statutory figure exceeds accumulated earnings and profits at the close of the preceding year. There is no reasonable-needs credit available to it at all, and IRC § 533(b) makes its status prima facie evidence of the purpose to avoid shareholder tax.

5. A corporation with 4,000 shareholders is found to have accumulated beyond its reasonable needs. Can the accumulated earnings tax apply?

Answer: yes. IRC § 532(c) provides that the application of the tax is determined without regard to the number of shareholders. It is not confined to closely held corporations, and the excepted categories in IRC § 532(b) are personal holding companies, subchapter F exempt organisations and passive foreign investment companies — none of which turns on shareholder count.