A tax that many CPAs in practice may not have run into recently was the subject of Chief Counsel Advice 201653017—the accumulated earnings tax imposed by IRC §531. While the tax technically applies to any C corporation, in reality it is only asserted against small privately held C corporations. Since small, privately held C corporations have been rarely seen in most practices since the passage of the Tax Reform Act of 1986 and the repeal of the General Utilities doctrine, the IRS has not had many chances to assert this tax and many CPAs have never seen the tax asserted.
The tax is imposed by IRC §531 which provides:
In addition to other taxes imposed by this chapter, there is hereby imposed for each taxable year on the accumulated taxable income (as defined in section 535) of each corporation described in section 532, an accumulated earnings tax equal to 20 percent of the accumulated taxable income.
IRC §532 provides that the tax applies to “every corporation…formed or availed of for the purpose of avoiding the income tax with respect to its shareholders or the shareholders of any other corporation, by permitting earnings and profits to accumulate instead of being divided or distributed.” Exempted from this tax are personal holding companies, corporations that are exempt from tax and passive foreign investment companies.
The tax applies generally to the cumulative earnings of the corporation less dividends paid. [IRC §535(a)] However, those earnings are reduced by the amounts retained for the reasonable needs of the business, referred to as the “accumulated earnings credit.” [IRC §535(c)] At a minimum, for companies other than holding and investment companies, the accumulated earnings credit is set to a minimum of $250,000 ($150,000 for certain service corporations).
The tax is not one that is volunteered by the corporation in virtually any case—rather, it is a tax the IRS generally asserts on examination of the entity. Per IRC §534 the burden is on the IRS to demonstrate that all or part of the accumulation is unreasonable.
In this case the C corporation in question was owned by a single individual. That individual had formed the corporation by contributing to the corporation the shareholder’s interests in eight partnerships. One of the partnership served as the manager for all of the other partnerships. The taxpayer was one of six board members that managed the management partnership.
Since actions of the board required the consent of a majority of board members, the shareholder could not, by himself, cause the partnerships to distribute cash to the corporation. The partnership agreement allowed for distributions to each partner to meet its federal and state tax liability, but required all other funds to be retained in the partnership.
The partnerships reported income almost exclusively from hedge fund management fees and offshore investment fees. The only items reported on the corporation’s income tax return was the income flowing through from the partnerships, expenses flowing from the partnerships and a minimal amount of corporate expenses.
The taxpayer argued that, due to the lack of liquidity, the accumulated earnings tax should not apply. After all, the argument went, the taxpayer had no funds with which to pay a dividend and had no way to force the partnerships to give the corporation a distribution from which a dividend could be paid.
The taxpayer’s representative provided the following justification for the formation of the corporation:
According to Taxpayer’s representative, Shareholder contributed his partnership interests to Taxpayer to avoid potential taxation by various tax jurisdictions, such as State 2 where Partnership 1 is located, and Country where Shareholder resides. Taxpayer has not otherwise provided any information to show a reason for the accumulation of retained earnings, and a review of its Board of Director minutes for all three years at issue did not contain or provide any plans or information relating to the reasons for the accumulation.
The memorandum notes that the entity is a mere holding company, conducting no business of its own but simply holding the partnership interests. The memorandum notes that per IRC §535(b) “[t]he fact that any corporation is a mere holding or investment company shall be prima facie evidence of the purpose to avoid the income tax with respect to shareholders.”
The ruling points out:
Taxpayer has no activity other than holding and maintaining the various partnership interests transferred to it by Shareholder. Furthermore, none of the partnerships in which it owns an interest, controlling or otherwise, appears to perform any activity other than investment activity. Accordingly, Taxpayer is a mere holding or investment company, and there is at least prima facie evidence that the taxpayer was formed to avoid tax, as provided by § 533(b) and § 1.533-1(c).
The memorandum rejects the taxpayer’s view that the fact that the corporation had no cash with which to pay a dividend exempts it from the tax. The memorandum states:
Taxpayer seems to suggest that accumulated surplus must be represented by cash that is available for distribution. However, the Internal Revenue Code computes the accumulated earnings tax based on accumulated taxable income, and at least with respect to a mere holding company for which reasonable needs of a business are not relevant, it is not concerned with the liquid assets of the corporation. Section 535 uses “taxable income” as a starting point for defining “accumulated taxable income,” and none of the adjustments to taxable income provided in § 535(b) include the undistributed income of partnerships.
The memorandum goes on to note that IRC §565’s consent dividend procedures could be used by the corporation to pay a deemed dividend even without any cash. The memorandum continues:
The consent dividend procedures provided by § 565 were enacted to address situations where a corporation that accumulated earnings beyond its reasonable needs may lack the ability to pay dividends because of a lack of liquidity or for other reasons. In pertinent part, § 565(a) provides that if any person owns consent stock (meaning common stock or participating preferred stock as defined in § 565(f)(1) and § 1.565-6(a)) in a corporation on the last day of the taxable year of such corporation, and such person agrees, in a consent filed with the return of such corporation in accordance with regulations prescribed by the Secretary, to treat as a dividend the amount specified in such consent, the amount so specified shall constitute a consent dividend. In explaining the effect of consent, § 565(c) provides that the amount of the dividend shall be considered (1) as distributed in money by the corporation to the shareholder on the last day of the taxable year of the corporation and (2) as contributed to the capital of the corporation by the shareholder on such day.
Congress intended to treat corporations declaring consent dividends as if they made distributions even though they may lack the ability to actually do so. Because Taxpayer permitted its earnings and profits to accumulate, and because consent dividends could have been used by Taxpayer and Shareholder, Taxpayer’s sole and controlling shareholder, to divide or distribute those earnings and profits, Taxpayer remains subject to the accumulated earnings tax in spite of its lack of liquidity and lack of control over the partnerships in which it invests.
Based on this analysis, the memorandum concludes:
There is prima facie evidence that Taxpayer was formed to avoid income tax with respect to its shareholder. Taxpayer remains subject to the accumulated earnings tax irrespective of its lack of liquidity and lack of control over the partnerships in which it invests.