The TV show “Hoarders” doesn’t portray the obsessions of business owners. But you might trigger tax problems if you can’t help stockpiling too much cash in the company’s cupboards.
Strategy: Do your best to avoid the “accumulated earnings tax.” This little-publicized penalty tax will be tacked onto your regular corporate income tax bill if you don’t stay within the prescribed tax law limits.
However, the outlook isn’t as bleak as before. Until Congress passed the new American Taxpayer Relief Act (ATRA), the tax rate for the accumulated earnings tax was poised to practically triple in 2013 to 39.6%. But ATRA permanently installs a much-lower 20% rate.
Here’s the whole story: The accumulated earnings tax is intended to discourage excessive accumulations of funds within a company. It applies to “accumulated taxable income,” which is defined as the company’s taxable income (with certain adjustments) minus the dividends-paid deduction and an accumulated tax credit. The minimum tax credit for this purpose is $250,000; $150,000 for personal service corporations.
Thus, if you can keep the cash in your company’s coffers below the $250,000/$150,000 mark for the year, you’re in the clear.
Otherwise, your corporation will be liable for the accumulated earnings tax. Previously, the tax rate was 15% in 2012, based on the preferential tax treatment for qualified dividends. However, because dividends were scheduled to be taxed at ordinary income rates in 2013, the applicable tax rate for the accumulated earnings tax would have been 39.6%. Since ATRA established a maximum 20% federal income rate on qualified dividends for 2013 and beyond, the accumulated earning tax rate is also now 20%.
What’s more, if you exceed the minimum credit amount, there’s a fallback position: No penalty is imposed on amounts accumulated for a “reasonable business need.” To qualify under this safe harbor rule, you must show that you have a definite plan in place for using the money in the applicable tax year (see box below).
5 steps to nail it down
Other factors may come into play. For instance, if you own a business in a volatile industry, you might have a better argument for accumulating cash than other businesses. Take these five steps to strengthen your case for accumulating more cash.
- Adopt a consistent dividend-paying policy.
- Obtain expert opinions to support anticipated replacement costs.
- Do the same for accumulations to safeguard against business hazards.
- Move expansion plans into the blueprint stage as soon as possible.
- Keep detailed records of valid business reasons for accumulating earnings in the corporate minutes. This is the best proof your company can have for justifying any excess amounts.
Tip: If it’s a close call, pay enough dividends to stay below the $250,000/$150,000 mark.
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