In the current economic climate, it’s a good idea for your company to save money for a rainy day. But you can run into serious tax trouble if you hoard too much cash in the corporate cupboard.
Strategy: Stay within the prescribed tax-law limits. Otherwise, your company could be socked with the “accumulated earnings tax.” This penalty tax is tacked onto the regular corporate income tax.
The accumulated earnings tax for 2009 is pegged to the tax rate for qualified dividends. However, in a few years the rate returns to the highest income tax rate for individuals—more than double the current rate!
Here’s the whole story: Prior to 2003, dividends were taxed at ordinary income rates reaching as high as 39.6%. So high-income business owners had a powerful tax incentive to stockpile company profits and earnings instead of paying out dividends.
The accumulated earnings tax was designed to avoid excessive accumulations within a company. It applies to “accumulated taxable income,” which is taxable income, with certain adjustments, less the dividends-paid deduction and an accumulated tax credit. The minimum credit for this purpose is $250,000 ($150,000 for personal service corporations).
So if you keep your company’s accumulation below the $250,000/$150,000 mark for the year, you’re completely in the clear.
A 2003 tax law reduced the tax on qualified dividends to 15% through 2008. At the same time, it lowered the rate for the accumulated earnings tax to 15%. The 15% tax rate for the penalty tax has since been extended through 2010. Then, it reverts to a whopping 35%.
Even with the current 15% rate, this is a stiff price to pay for keeping emergency funds on hand.
Fortunately, if you exceed the minimum credit amount, there’s a fallback position. No penalty tax is imposed on amounts accumulated for a “reasonable business need.” To qualify under this safe harbor, you must show that you have a definite plan for using the money and that the plan was in place during the applicable tax year (see box).
Five steps to nail it down
Other factors may come into play. For instance, a business in a fast-changing, high-tech industry may have a better argument for accumulating funds than one in a more traditional line of work. Similarly, if your firm is in a highly competitive field, you may need additional funds.
Take these five steps to strengthen your case:
- Adopt a consistent dividend policy.
- Obtain expert independent engineering 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.
- Record all 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: Keep an eye on the $250,000/$150,000 limit, but don’t back off from legit accumulations.
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