Accumulated Earnings Tax

accumulated earnings tax

A federal tax on a company's retained earnings that are considered in excess of what is reasonable. The purpose of an accumulated earnings tax is to make it more difficult to defer or lower the tax rate (that is, change from ordinary income to capital gains) on income that would ordinarily be paid to stockholders in dividends. For example, stockholders in high tax brackets generally prefer earnings be retained rather than paid in dividends so that they can avoid being taxed at ordinary rates. The position of the Internal Revenue Service is that if the funds are not actually needed by the firm and are only being retained for tax reasons, the accumulated earnings should be taxed.

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Accumulated Earnings Tax

In the United States, a tax on a corporation for retained earnings the IRS deems to be excessive. Retained earnings are profits that are not paid out in dividends. Companies with a low payout ratio generally experience higher price appreciation on their stock, which would subject shareholders to a higher capital gains tax when they sell, rather than a higher tax on dividends. However, the tax rate on capital gains is lower than the tax on dividends. Thus, the accumulated earnings tax exists to ensure that the government is able to receive roughly the same amount in revenue regardless of how much or how little the corporation distributes in dividends.