The federal accumulated earnings tax (AET) is imposed on companies that have retained earnings deemed unreasonable and in excess of the ordinary by the IRS. Essentially, this tax encourages companies to issue dividends rather than retain the earnings. And it could impact taxation related to C corporations, which tend to accumulate their earnings or profits instead of distributing them as dividends to shareholders.

Tax reform – especially given new rules on pass-through income – has probably already made C and S corporations a bigger topic of discussion with many of your wealthy clients. At the same time, many business-owning high-net-worth clients might not know about the AET.

“Most businesses do not retain excess earnings,” said Richard Kollauf, CPA/CFP and vice president and director of business advisory and estate planning with BMO Private Bank in Milwaukee. “The earnings retained are usually held for future growth and re-investment in the business.”

The AET isn’t commonly understood among business owners, he added, and unless their tax accountant or an IRS auditor brings it up most are unlikely to ever need to know about it. Furthermore, Kollauf said, many high-net-worth C corporation owners traditionally zero out their annual business earnings through compensation or bonuses at year’s end to avoid the potential of this double tax.

The troublesome misconception is “that they can do as they wish with their earnings without penalty,” Kollauf said.

These companies may accumulate earnings up to $250,000 without triggering the AET, which is 20 percent on earnings over the exemption amount. The tax aims to make sure that wealthy individuals don’t house assets inside an S Corp and have them taxed at cheaper rates.

“Unlike most taxes, it is not voluntarily assessed—the IRS would bring it up on audit if they see it as an issue,” said Mike Crabtree, J.D./CPA and partner with Boulay in Minneapolis. “Usually it affects very profitable corporations that are owned by families that don’t need to take the cash out and would prefer to avoid the double taxation that comes with C corps.”

Added Jim Wilhelm, tax director at SC&H Group, a CPA and consulting firm in Sparks, Md., “You don’t self-report the AET; generally it gets assessed in an audit, It’s always a surprise, I think.”

You will most often see the IRS poking around this area if the C Corp is a holding company or serves to merely hold investments and isn’t making adequate distributions, Kollauf said.

“Note that the AET doesn’t apply to personal holding companies, as they have a special taxation on undistributed income” he said.

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