Two Penalty Taxes on C Corporations That Keep Cash
The accumulated earnings tax and the personal holding company tax: when a C corporation's retained profits or passive income trigger an extra 20 percent, and how to stay clear.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
Two penalty taxes keep C corporations from being used as tax-deferred savings accounts. The accumulated earnings tax adds 20 percent to earnings retained beyond the reasonable needs of the business, above a $250,000 credit. The personal holding company tax adds 20 percent to undistributed passive income of a corporation more than half owned by five or fewer individuals.
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How do the two compare?
| Feature | Accumulated earnings tax | Personal holding company tax |
|---|---|---|
| Target | Profits retained to avoid shareholder tax on dividends | Closely held corporations holding mostly passive income |
| Rate | 20 percent of accumulated taxable income | 20 percent of undistributed personal holding company income |
| Threshold | Accumulations above $250,000 ($150,000 for corporations whose principal function is services in health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; a controlled group shares one amount) without a documented business need | More than half the stock by value owned by five or fewer individuals at any time in the last half of the year, and 60 percent or more of adjusted ordinary gross income from dividends, interest, rents, royalties, or personal service contracts |
| Intent | Required — but accumulating beyond reasonable needs establishes the tax-avoidance purpose unless the corporation proves otherwise by a preponderance of the evidence (Section 533) | Mechanical — no intent needed |
| Cure | Pay dividends (those paid by the 15th day of the fourth month after year-end count for the prior year); document plans for the cash | Pay dividends, including a deficiency dividend paid within 90 days after an IRS determination (interest and penalties still apply) |
What counts as a reasonable need?
Working capital for one operating cycle (courts use a formula based on inventory, receivables, and payables turnover), specific and definite plans for expansion or equipment, debt retirement, a planned acquisition, reserves for realistic business hazards such as product liability losses, and redemption needs such as buying back a deceased shareholder's stock to pay estate taxes (Section 303). Vague intentions to grow someday, loans to shareholders, and investment portfolios unrelated to the business are not needs. Board minutes recording the plans and the amounts are the evidence.
Who is exposed to the personal holding company tax?
A family corporation that sold its operating business and kept the proceeds invested; a corporation holding rental property with few owners; a corporation whose income is from contracts that name (or let the client designate) the owner to perform the services, when that owner holds 25 percent or more of the stock. Rents can escape the test if they are at least half of adjusted ordinary gross income and dividends paid at least equal the corporation's other passive income in excess of 10 percent of ordinary gross income.
How do owners manage it?
Pay enough dividends to stay under the thresholds, document business needs annually, move passive investments out of the corporation, or elect S status where eligible — S corporations are outside both taxes, though the built-in gains tax and passive investment income rules apply after conversion.
Frequently asked questions
Does the accumulated earnings tax apply to a corporation with a single shareholder?
Yes. Closely held corporations are the usual targets.
Can a corporation hold investments without triggering either tax?
For the accumulated earnings tax, within the credit and with documented needs, yes; a growing portfolio unrelated to operations is what draws attention. But if passive income reaches 60 percent of adjusted ordinary gross income and five or fewer individuals own more than half the stock, the personal holding company tax applies regardless of business needs unless the income is distributed.
Is the tax in addition to the 21 percent corporate rate?
Yes. It is a separate penalty tax on top of regular corporate income tax.
Does paying salary instead of dividends help?
Reasonable salary reduces corporate taxable income, but salary above what is reasonable can be reclassified as a dividend.
Official sources
The statute 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.” — Legal Information Institute, Cornell Law School, 26 U.S. Code § 531 - Imposition of accumulated earnings tax, https://www.law.cornell.edu/uscode/text/26/531
The IRS explains: “A corporation may be subject to the PHC tax if at least 60% of its adjusted ordinary gross income for the tax year is PHC income. Use Part II to figure the amount of the corporation's PHC income.” — Internal Revenue Service, Instructions for Schedule PH (Form 1120) (12/2016), https://www.irs.gov/instructions/i1120sph
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