PENALTY TAXES ON CORPORATE ACCUMULATIONS

H Chapter Six H PENALTY TAXES ON CORPORATE ACCUMULATIONS INTRODUCTION AND STUDY OBJECTIVES The accumuated earnings tax and the persona hoding company tax are penaty taxes designed to prevent taxpayers from using the corporation for tax avoidance. Both taxes are imposed on unwarranted accumuations of income that woud have been taxabe to the individua if it had been distributed. The purpose of the two penaty taxes is to compe distributions, thereby discouraging taxpayers from using the corporation for tax avoidance purposes. In studying the rues of corporate accumuations, the student shoud have these objectives: 1. To earn the rues reated to the assessment of the accumuated earnings penaty tax. 2. To earn the rues reated to the imposition of the persona hoding company penaty tax. 3. To understand when the rues of both penaty taxes wi be appied. 4. To become famiiar with various methods that are avaiabe to the taxpayer to avoid assessment of the penaty. ACCUMULATED EARNINGS TAX STUDY HIGHLIGHTS 1. The accumuated earnings tax is a penaty tax designed to discourage the excessive accumuation of earnings by a corporation. The tax aims at forcing the corporation to distribute its earnings to the sharehoders, who then in turn pay taxes on dividend income. Whether income is being accumuated for the forbidden purpose of avoiding taxes requires a determination of the taxpayer s intent. 2. The accumuated earnings tax is cacuated as foows: Taxabe income þ The dividends-received deduction þ The net operating oss deduction þ Capita oss carryovers incuded in taxabe income Federa income taxes (excuding penaty taxes) Charitabe contributions in excess of the 10% imitation Net capita osses incurred during the year Net LTCG over Net STCL (net of taxes) ¼ Accumuated taxabe income Accumuated earnings credit Dividends-paid deductions ¼ Accumuated taxabe income 15 ¼ Accumuated earnings penaty tax For tax years beginning after 2002 (as extended each year) the penaty tax is 15%. 6-1

6-2 Penaty Taxes on Corporate Accumuations Exampe. J corporation, a nonservice company, has the foowing transactions during the year. Taxabe income $450,000 Tax iabiity 150,375 Excess charitabe contributions 33,000 Short-term capita oss (60,000) Dividends received 150,000 Dividends paid 60,000 Accumuated earnings from prior years 220,000 Assuming no reasonabe business needs to justify additiona accumuations, the 531 penaty tax is cacuated as foows: Taxabe income $450,000 Pus: 80% Dividends-received deduction 120,000 $570,000 Less: Tax iabiity (150,375) Excess charitabe contribution (33,000) Net short-term capita oss (60,000) Dividends paid (60,000) Remaining accumuated earnings credit (30,000) ($250,000 $220,000) Accumuated Taxabe Income $236,625 The penaty tax for the year woud be ($236,625 15%) ¼ $35,494. 3. The accumuated earnings credit is a reduction in arriving at accumuated taxabe income. The amount of the credit is the greater of: $250,000 minus the accumuated earnings and profits at the end of the prior year, or The current earnings and profits retained for the reasonabe needs of the business minus net LTCG over set STCL (net of taxes). 4. The accumuated earnings credit is reduced to $150,000 for corporations primariy engaged in the business of providing professiona services (e.g., accountants, attorneys, engineers, etc.). 5. The dividends-paid deduction comprises the foowing dividends: Dividends paid during the taxabe year not previousy used. Dividends paid within 2.5 months after the cose of the taxabe year. Consent dividends. Liquidating dividends.

Study Highights 6-3 6. Consent dividends are not actuay paid to the sharehoders; nonetheess, the sharehoders must incude them in computing their taxabe income as if they had received an actua distribution. A consent dividend wi increase the basis of the sharehoder s stock. 7. Reasonabe business needs is not defined in the code. The Reguations state that reasonabe business needs incude Capita for bona fide expansion of the business. Provisions for the retirement of bona fide indebtedness. Reserves for pending itigation. Investments or oans to suppiers. Provisions for working capita needs. 8. The courts have deveoped an operating-cyce approach to determine the working capita needs of a business. This approach, known as the Bardah formua, permits an accumuation equa to the cost of operating a business for a singe operating cyce. See Exampe 6 in the textbook for an exceent iustration. 9. Because the accumuations tax is assessed upon the sharehoder s intent, the need for the penaty is based upon a subjective assessment. The burden of proof is generay paced upon the taxpayer; however, the burden can be shifted to the IRS. To shift the burden, the corporation must respond within 60 days after a notice is received from the IRS requesting information as to the reasonabeness of the corporation s accumuation of earnings. PERSONAL HOLDING COMPANY 10. The persona hoding company tax is aimed at so-caed incorporated pocketbooks and incorporated taent. These are corporations estabished to receive and hod investment income or compensation of its sharehoders in order to shied that income from the higher individua tax rates that woud appy had the income been received by the sharehoders. 11. Certain companies are exempt from the persona hoding company penaty tax. These incude banks, savings and oan associations, most finance companies, and ife insurance and surety companies. 12. A persona hoding company is any corporation that meets both of the foowing tests: a. Ownership: At any time during the ast haf of the taxabe year more than 50 percent of its outstanding stock is owned, directy or indirecty, by up to five individuas. b. Passive income: At east 60 percent of the corporation s adjusted ordinary gross income (AOGI) consists of persona hoding company income (PHCI). 13. The attribution rues of 544 are used in determining the stock ownership test. 14. AOGI is cacuated as foows: ¼ ¼ Gross income Capita gains 1231 gains Ordinary gross income (OGI) Deductions reated to renta and royaty income Adjusted ordinary gross income (AOGI)

6-4 Penaty Taxes on Corporate Accumuations 15. PHCI is essentiay passive income such as dividends, interest, rents, and royaties. However, in some cases, amounts received under persona service contracts or as compensation for the use of corporate property by sharehoders are aso incuded in PHCI. See Chapter 6, Exhibit 8 in the textbook for a more thorough description. 16. Renta income is normay cassified as PHCI. However, if two specific tests are met, adjusted rents (gross rents minus directy reated expenses) are excuded from the PHCI category. The test for excusion requires that both of the foowing be met: a. 50 percent or more of the corporation s AOGI is adjusted income from rents. b. Dividends paid during the year equa or exceed nonrent PHCI minus 10 percent of OGI. Exampe. N Corporation has gross income for the year of $40,000, which incudes $30,000 in renta income, $8,000 in dividends, and a $2,000 ong-term capita gain. Expenses reated to the renta income are $20,000 and the company paid dividends of $5,000. AOGI must be cacuated first: Gross income $40,000 Capita gain (2,000) ¼ OGI $38,000 Renta expenses (20,000) ¼ AOGI $18,000 Next adjusted income for rents must be 50 percent or more of AOGI: Renta income $30,000 Renta expenses (20,000) Adjusted income from rents $10,000 50% of AOGI ($18,000) 9,000 TEST I satisfied Next dividends paid must exceed nonrent PHC minus 10 percent of OGI: Nonrent PHC income $8,000 10% of OGI (3,800) Excess $4,200 Dividends paid $5,000 Since both tests are satisfied, the company is aowed to excude renta income (net of expenses) in determining the amount of passive income for the year. Accordingy, PHCI amounts to $8,000 (dividends ony). 17. Additiona tests exist to excude adjusted income from minera oi and gas royaties as we as compensation for the use of property by a sharehoder.

Study Highights 6-5 18. Prior to the Tax Reform Act of 1986, the persona hoding company penaty tax was 50 percent of undistributed persona hoding company income (UPHCI). The Tax Reform Act reduced the rate to 39.6 percent. Currenty, the rate is (for years beginning after 2002) 15 percent of UPHCI. The computation is iustrated as foows: þ þ þ ¼ ¼ ¼ Taxabe income Dividends-received deduction Net operating oss deduction (except prior year NOL aowed without a dividends-received deduction) 162 pus 167 deductions reated to rent exceeding renta income Federa income taxes (excuding penaty taxes) Charitabe contributions in excess of the 10% imitation Net LTCG over net STCL (net of taxes) Adjusted taxabe income Dividends-paid deduction Undistributed persona hoding company income Appicabe tax rate Persona hoding company penaty tax 19. The dividends-paid deduction for a persona hoding company incudes the foowing types of dividends: Those dividends paid during the taxabe year. Dividends paid within 2ø months after the cose of the taxabe year. Consent dividends. Carryover dividends. Deficiency dividends. Liquidating distributions. 20. Carryover dividends are the excess of dividends paid in the prior two years over the adjusted taxabe income for those years. 21. A deficiency dividend is an actua dividend paid within 90 days of a determination that a persona hoding company penaty iabiity exists. A deficiency dividend ony reduces the amount of the penaty tax and wi not eiminate the assessment of penaties and interest. 22. The IRS cannot assess both an accumuated earnings penaty tax as we as a persona hoding company penaty tax in any one year. 23. Under 6501(f), the persona hoding company tax on a persona hoding company (PHC) that did not fie a PHC schedue with its income tax return may be assessed for up to six years after the income tax return was fied.

6-6 Penaty Taxes on Corporate Accumuations True or Fase STUDY QUESTIONS 1. The tax aw is designed to discourage the retention of earnings in a corporation beyond the norma business needs. 2. Tax avoidance needs to be the controing reason for retaining earnings in the corporation before imposition of the accumuated earnings penaty tax. 3. The accumuated earnings tax is ony imposed on that income which is in excess of the reasonabe needs of the business. 4. A reserve to pay stock dividends woud be considered a reasonabe need of the business. 5. Accumuated taxabe income equas taxabe income, pus or minus certain adjustments, pus the dividends-paid deduction, minus the accumuated earnings credit. 6. The persona hoding company penaty tax was imposed to discourage the shetering of passive income in a persona hoding company. 7. The persona hoding company tax is added to the reguar tax and equas 50 percent of the undistributed persona hoding company income. 8. Adjusted ordinary gross income (AOGI) is gross income (GI) ess capita gains. 9. An S corporation eection wi circumvent the appication of the 531 penaty tax. 10. The penaty taxes under 531 are very objective, whie the penaty taxes under 541 are subjective. 11. A corporation can be subject to the accumuated earnings penaty as we as the persona hoding company penaty if both vioations occur. Mutipe Choice 1. The accumuated earnings tax imposed on corporations for improper accumuation of earnings in excess of reasonabe needs does not appy to which of the foowing? a. Cosey hed corporations. b. Widey hed corporations. c. Pubicy hed corporations. d. Persona hoding companies. e. None of the above. 2. In determining whether a corporation is subject to the accumuated earnings tax, which of the foowing items is not a subtraction in arriving at accumuated taxabe income? a. Federa income tax. b. Capita oss carryback. c. Dividends-paid deduction. d. Accumuated earnings credit. e. Excess charitabe contributions over the 10 percent imit paid during the year.

Study Questions 6-7 3. What amount of accumuated earnings of a service corporation wi be considered within the reasonabe needs of a business without the corporation having to show a bona fide business reason for the accumuation? a. $150,000 or ess. b. $200,000 or ess. c. $250,000 or ess. d. $300,000 or ess. e. $350,000 or more. 4. Which of the foowing woud not be considered reasonabe needs of a business in determining the accumuated earnings tax? a. Specific pans to update factory machinery. b. Definite ong-range commitment to purchase raw materias. c. A feasibe ong-range pan to expand factory productions. d. An amount, with certain imitations, necessary to redeem the corporation s stock incuded in a deceased stockhoder s gross estate. e. Specific and feasibe pan to decare a stock dividend to a sharehoders. 5. D Corporation, which is not a hoding company, derives its income from retai saes. D had accumuated earnings and profits at December 31, 2007, of $145,000. For the year ended December 31, 2008, it had earnings and profits of $115,000 and a dividends-paid deduction of $15,000. It has been determined that $20,000 of the accumuated earnings and profits for 2008 is required for the reasonabe needs of the business. How much is the aowabe accumuated earnings credit at December 31, 2008? a. $105,000. b. $125,000. c. $150,000. d. $250,000. e. None of the above. 6. Which of the foowing types of income is not considered persona hoding company income? a. Dividends. b. Interest. c. Royaties. d. Annuities. e. Capita gains. 7. Which of the foowing rates is used to compute the persona hoding company tax for 2008? a. 28 percent. b. 34 percent. c. 39.6 percent. d. 50 percent. e. 70 percent.

6-8 Penaty Taxes on Corporate Accumuations 8. Which of the foowing are deemed reasonabe business needs for the accumuated earnings credit? a. Loans to customers. b. Loans to sharehoders. c. Loans to friends. d. Loans to famiy members. e. None of the above. 9. Which one of the foowing is not used as a method of avoiding doube taxation? a. Mutipe corporations. b. Excessive compensation for services to the corporation by sharehoder. c. Issuance of debt in ieu of stock. d. Leasing of property to the corporation by sharehoder. e. None of the above. 10. In cacuating adjusted taxabe income for accumuated earnings tax purposes, which one of the foowing is not subtracted from taxabe income? a. Reguar Federa income taxes for the year. b. Dividends-paid deduction. c. Charitabe contributions in excess of aowabe deduction. d. Net capita oss. e. Net capita gains. 11. B Corporation, a service company, operates on a caendar year and has paid no dividends for three years. What woud its accumuated earnings credit be? a. $85,000. b. $90,100. c. $100,000. d. $150,000. e. $250,000. Estimated reasonabe needs for the current year $200,000 Prior accumuations 100,000 Net capita gain 15,000 Taxes attributed to capita gain 5,100 12. Which one of the foowing is not part of the dividends-paid deduction for accumuated earnings tax purposes? a. Dividends paid within 2ø months after the cose of the tax year ( throwback dividends ). b. Dividends paid during the year. c. Deficiency dividends. d. Consent dividends paid on the ast day of the year. e. None of the above.

Study Questions 6-9 13. Section 533, Accumuated Earnings Tax, provides that a corporation is deemed to have been formed or avaied of for the purpose of avoiding tax on sharehoders if a. the corporation is a hoding or an investment company. b. the corporation has accumuations in excess of the designated minimum credit. c. the corporation has invested in assets unreated to the corporation s business. d. the corporation has paid no dividends. e. the corporation has ten or fewer sharehoders. 14. A Corporation has $400,000 of accumuated taxabe income. Its accumuated earnings tax for 2008 is: a. $158,400. b. $124,000. c. $112,000. d. $60,000. e. Can t be determined from the information provided. Fi In the Banks 1. The penaty tax associated with the unreasonabe surpusing of earnings is the tax. 2. The 531 penaty tax rate is percent for 2008. 3. A consent dividend is an exampe of the deduction. 4. The accumuated earnings penaty tax wi not be assessed if the corporation has needs. 5. The formua was deveoped to hep determine the working capita needs of the corporation. 6. The tax is aimed at preventing incorporated pocketbooks. 7. The 541 penaty tax rate is percent for 2008. 8. Carryover dividends are the excess dividends paid in the prior years over the adjusted taxabe income for those years. Code Section Recognition For each of the foowing Code sections, try to match the response that most propery identifies the underying provision. 1. 531 a. imposition of persona hoding company tax 2. 535 b. imposition of accumuated earnings tax 3. 541 c. definition of dividends-paid deduction 4. 547 d. accumuated taxabe income defined 5. 561 e. deduction for deficiency dividends

6-10 Penaty Taxes on Corporate Accumuations SOLUTIONS TO STUDY QUESTIONS True or Fase 1. True. 2. Fase. It is ony one of the factors considered, athough it is a major consideration. 3. True. 4. Fase. Dividends are not business-reated. 5. Fase. Less the dividends-paid deduction. 6. True. 7. True. 8. Fase. The definition given describes ordinary gross income. 9. True. 10. Fase. Section 531 is subjective and 541 is objective. 11. Fase. Either penaty can appy, but not both. Mutipe Choice 1. d. 2. b. 3. a. The credit for service corporations is $150,000 versus $250,000 for nonservice corporations. 4. e. 5. a. ($250,000 $145,000). $20,000 is smaer and therefore not considered. 6. e. 7. c. 8. a. 9. a. 10. b.

Soutions to Study Questions 6-11 11. b. ($200,000 $100,000 $15,000 þ $5,100) ¼ $90,100. 12. c. 13. a. 14. d. ($400,000 @ 15%) ¼ $60,000. Fi In the Banks 1. Accumuated earnings. 2. 15. 3. Dividends-paid. 4. Reasonabe business. 5. Bardah. 6. Persona hoding company. 7. 15. 8. Two. Code Section Recognition 1. b. 2. d. 3. a. 4. e. 5. c.