Defending the Accumulated Earnings Tax Case

Summary: The legal firm and attorneys are helping a famous singer deal with a contract issue. They are demanding fair treatment and compensation for the singer. The penalty tax for the unreasonable accumulation of corporate earnings is a part of the Tax Code and is meant to prevent corporations from keeping too much money without paying it as dividends to shareholders. The tax equals 39.6 percent of the accumulated taxable income and is in addition to the regular corporate tax. It applies to most private and public subchapter “C” corporations, with closely held corporations being the most likely targets. The tax is meant to penalize corporations for not distributing earnings that are not needed for legitimate business purposes. The critical question in these cases is whether the retention of earnings can be justified by the reasonable needs of the business. The reasonable business needs of a corporation include not only its current needs, but also its “reasonably anticipated” future business needs. The excess cash not needed should be distributed to shareholders as dividends. This article discusses the difficulty in proving “reasonable business needs” during an audit or trial, and explores business needs that are often overlooked when a corporation has to justify its retained earnings. The article also looks at specific factors that may indicate a motive to unreasonably accumulate earnings, such as making personal loans to shareholders or investing in businesses unrelated to the corporation’s business. These factors can distract from the main issue of whether the corporation’s business needs exceed its available funds. In an accumulated earnings tax case, a corporation may be penalized if it retains too much money instead of using it for business purposes. Factors like excessive cash reserves or investments unrelated to the business can be indicators of unreasonable accumulations. However, a corporation can argue that its business needs justify the retained earnings. For example, if it can show that its cash reserves are low because a shareholder made a loan to the corporation, it strengthens its case. The term “working capital” in this context refers to the funds available for the corporation’s business needs, and it is measured against the demand for capital. In a nutshell, the Bardahl formula helps businesses figure out how much money they need for their day-to-day operations. It takes into account things like how long it takes to turn raw materials into products, and how long it takes for customers to pay for those products. The formula also considers how much money the business can get from suppliers on credit. This helps figure out how much cash the business needs to have on hand at any given time. This calculation is important for tax purposes, and it’s different from proving other business needs. The Tax Court is saying that every company should assume it will always get the benefit of credit from its creditors and operate using that borrowed money. But other courts have said that it’s not fair to force a company to rely on credit if it doesn’t want to. The IRS even said that a company might not need any working capital at all if it uses credit. Until there’s a clear rule on this, a company should be careful about agreeing to a reduced working capital amount based on credit, and be ready to argue against it in court. Business plans need to be clearly documented in the corporation’s minutes or financial statements. It’s important to review and update these plans regularly. If plans are not fulfilled, it may show that the funds were not justified in the first place. Without documented plans, it’s difficult to prove their existence, but actual spending after the year in question can help. Every business has financial needs that may support the retention of corporate funds. One example is self-insurance reserves, which can be used to cover risks that regular insurance may not cover. It’s important for a business to document their decision to self-insure in order to show that it’s a reasonable business need. This can be done with the help of insurance agencies or other experts. In a family-owned business, it may be necessary to save money in case shareholders want to sell their stock back to the company. This can be part of the business plan, but it’s important to be careful not to rely too much on this need. Courts may not always agree that the business needs to save money for this purpose. If the business doesn’t have money saved, it will have to borrow money in the future, which can be costly. When choosing where to go to trial for a case about accumulated earnings tax, it’s important to look at past cases in different court districts. The Tax Court often has procedures that make it easier for the business to prove its needs, so it’s a good option to consider. Even though it may seem risky to show all your evidence early in the case, it’s likely that the other side will already know most of it from the years of audit and appeals leading up to trial. So, it’s important to consider the burden of proof when deciding where to go to trial and how to present the case. As long as §531 is part of the Tax Code, businesses need to be careful about how much money they keep in their accounts. They should have a good reason for keeping extra money, like for growing the business or dealing with unexpected problems. Businesses should also keep their business plans up to date to show why they need the extra funds. Just paying out dividends to shareholders isn’t enough to prove that the money is needed for the business. In some cases, even companies that paid out a lot of dividends had to defend themselves in court against challenges to their extra funds. In one case, the company had to prove that they weren’t trying to avoid paying taxes on the extra money. So, businesses need to be careful about how they use and keep their money to avoid legal trouble. For businesses that have a lot of money saved up, it’s a good idea to change to the “S” corporate form to avoid future problems. But if they can’t do that, they need to think carefully about how much money they really need for their business before the end of the year. They should consider things like how the economy is doing and the business’s own unique needs. It’s important for businesses to show that they really need the money they’re keeping and to pay their employees fair salaries. If they can do that, they have a better chance of avoiding any trouble with the tax authorities. The accumulated earnings tax is a tax that applies to corporations that keep too much money in their accounts, instead of distributing it to shareholders. The minimum credit is $250,000, but some professional service corporations can claim a credit of $150,000. The tax can be avoided if the corporation can prove it didn’t intend to avoid taxes. The burden of proof in tax proceedings is usually on the corporation. If the corporation doesn’t have a good reason for keeping a lot of money, they may have to pay the tax. John S. Ball and Beverly H. Furtick are lawyers at a law firm in Jacksonville. John focuses on taxes and has a special certification in tax law. Beverly focuses on planning people’s estates and also has a special certification. They both received their law degrees from different universities. This column is written on behalf of the Tax Law Section by the chair, J. Bob Humphries, and the editors, Michael C. Miller and Lester Law. The mission of the Florida Bar is to encourage its members to serve the public, improve the justice system, and advance the study of law.

Source: https://www.floridabar.org/the-florida-bar-journal/defending-the-accumulated-earnings-tax-case/