Defending the Accumulated Earnings Tax Case
The penalty tax for the unreasonable accumulation of corporate earnings has formed a part of the Tax Code for many years, and is viewed as a necessary component of the federal system which taxes corporate earnings both to the entity and then again to the owners once they are distributed. The §531 penalty tax is designed to prevent corporations from unreasonably retaining after-tax liquid funds in lieu of paying current dividends to shareholders, where they would be again taxed as ordinary income at shareholder tax rates. The accumulated earnings tax equals 39.6 percent of “accumulated taxable income” and is in addition to the regular corporate tax.1 Accumulated taxable income is taxable income modified by adjustments in §535(b), and as reduced by the dividends paid deduction under §561 and the accumulated earnings tax credit under §535(c).2
Although the top individual tax rates are approximately the same as the combined federal and Florida corporate tax rates, an individual bent on avoiding taxes arguably could use the corporate form to unreasonably accumulate after-tax corporate earnings, and later hope to bail out those earnings at capital gains rates on sale of the company. Alternatively, the shareholder may intend to retain the shares for the date of death basis step-up.3 Long term capital gains of individuals are now generally taxed at a maximum of 20 percent, rather than at the 39.6 percent top marginal rate on ordinary income. Consequently, as with the personal holding company tax, the accumulated earnings tax penalizes a corporation for failing to distribute earnings which are not needed for legitimate business purposes. Because the accumulated earnings tax is a penalty, it is, therefore, strictly construed.4
All private and public subchapter “C” corporations, with limited exceptions, are potentially subject to the accumulated earnings tax.5 Although publicly held corporations can be found to have liability for accumulated earnings tax,6 closely held corporations are the most likely targets of this assessment since their shareholders often are perceived to be in a better position to influence dividend policy. Corporations with a high degree of liquidity are vulnerable. The tax is levied on corporations “formed or availed of” for the purpose of avoiding income taxation of shareholders by accumulating, instead of distributing, its earnings. The penalty tax thus requires the intent to avoid tax at the shareholder level. The accumulation of earnings beyond the reasonable business needs of a corporation is determinative of intent to avoid shareholder taxes, unless disproved by a preponderance of the evidence.7 A corporation which has accumulated its earnings beyond its reasonable needs may still rebut the presumption of intent. However, in practice it is the unusual case indeed in which a closely held corporation with excess earnings and profits will be able to prove the lack of tax avoidance motive.8 The corporation must prove, by a preponderance of the evidence, that avoidance of shareholder taxes was not one of the purposes motivating its accumulation policies.9 The reasonable needs of the business not only are critical in determining whether the proscribed intent exists, but these needs also establish a credit amount which reduces accumulated taxable income in defining the tax base against which the penalty tax is applied.10
The critical inquiry in every accumulated earnings tax case, therefore, 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 as well. Under the standard of the Treasury Regulations, the needs of the business are determined at the close of the taxable year in issue.11 This is the point at which management presumably decides how much cash is needed for normal business operations, and for future adverse risks and contingencies. The excess not so needed, the theory goes, should then be distributed to the shareholders as dividends, to be taxed as ordinary income.
This article will review the difficulty in proving “reasonable business needs” on audit and at trial, and also will explore business needs often overlooked in the analysis of the working capital requirements of a corporation faced with the prospect of having to justify its retained earnings on audit.
Objective Factors of Intent
The applicable Treasury Regulations list specific factors which, if established, tend to indicate the presence of a motive to unreasonably accumulate earnings. The presence of such factors sometimes distracts the court from the central issue in the case. The core issue is always whether the corporation’s business needs exceed its available funds. For example, a shareholder loan is one such indicator of intent. The reason is apparent. Why would a corporation, which argues that it needed the cash reserves for its business, have made a loan to its shareholders or to a related party? When such a loan is made, it then must be explained and justified in a business context. The Treasury Regulations focus upon the potential abuse of the corporate form for the personal benefit of the shareholders, in listing the following nonexclusive factors which evidence the proscribed intent:12
1) Dealings between the corporation and its shareholders for the personal benefit of the shareholders, such as personal loans, or the expenditure of funds by the corporation for the personal benefit of the shareholders;
2) The investment of earnings in businesses or assets having no connection with the business of the corporation; and
3) A poor corporate dividend record.
Such factors, and other similar factors, are listed elsewhere in the regulations as also indicating generally that the retention of earnings and profits is not for business purposes, and may be excessive.13 Nevertheless, the indicia of unreasonable accumulations can be overcome with a proper foundation to show the reasonable needs of the business are indeed in excess of available corporate funds.14 Thus, if a corporation has invested in an asset which is neither liquid nor related to its business, such as an investment in raw land held for speculation, the corporation still may attempt to show that its business needs would still be unfunded even assuming the investment had never been made. The negative inference, however, is obvious and difficult to overcome. It is important to note that mere knowledge of the tax, and taking active steps to document business plans, are not adverse intent factors, despite the Commissioner’s attempts to argue otherwise. In a recent Tax Court case, the Internal Revenue Service was unsuccessful in asserting that a taxpayer’s knowledge of the accumulated earnings tax, and its use of Bardahl computations in its corporate minutes, indicated an intent to avoid the accumulated earnings tax.15
The corporation’s case will always be stronger if it can avoid the indicia of intent, and thus be in position to argue that all of its funds have either been reinvested in the business or are held in ready reserve for business needs. Furthermore, when possible, the corporation should use the Treasury Regulations to its advantage. If a shareholder has made a loan to the corporation, for example, it may tend to show, in a similarly objective fashion, that the corporation’s cash reserves are dangerously low. The after-tax earnings of the shareholders which are made available to benefit the corporation could be a persuasive factor in corroborating management’s decision to retain corporate earnings for business purposes. While not mentioned in the regulations, the payment of substantial salaries to shareholder-employees for services rendered is also regarded as a factor which tends to indicate tax avoidance at the shareholder level was not a motivating factor in the decision to retain corporate earnings.16
Working Capital Reserves
The term “working capital” has a speak meaning in the context of an accumulated earnings tax case. The penalty tax is imposed only if the corporation’s net liquid assets, generally consisting of the excess of its current assets over current liabilities, are in excess of its reasonable business needs. Current assets include inventories and accounts receivable, as well as cash and cash equivalents. Consequently, in this context, the term working capital refers simply to the funds available to the corporation for business purposes. The working capital needs of a business in an accumulated earnings tax case is given a narrower definition, and means the liquid assets needed for a regular business cycle, which then forms a very specific component of a corporation’s overall reasonable business needs. All business needs, including working capital needs, are measured against the funds available to meet the demand for capital.
Under the traditional Bardahl formula,17 The amount of liquid assets needed for a single operating or business cycle is automatically allowed as a business need in virtually every accumulated earnings tax case. The operating cycle for a manufacturing business is frequently described as the period of time needed to convert cash into raw materials, raw materials into inventory, inventory into accounts receivable, and accounts receivable into cash. Adjustments are made for a predominantly service business.18 Unlike other business needs, the issue is not whether the corporation can prove a need for a specific amount of working capital. Instead, the issue becomes one of proving the operating cycle for the specific business under consideration. The portion of the year represented by the operating cycle, expressed as a percentage, is then applied to annual operating cash expenditures to determine the working capital needs. Detailed plans and specificity are required to prove virtually all other business needs. When it comes to the needs for working capital for a single operating cycle, however, the courts engage in a fiction, and instead presume a reasonable businessperson will plan to retain enough cash at the end of the year to carry it through its normal operating cycle.
While the intricacies of calculating working capital needs under the Bardahl formula go beyond the scope of this article, the credit cycle component of the traditional formula deserves special mention. The Internal Revenue Manual, and the Tax Court itself in numerous cases, reduce on an automatic basis the length of the business operating cycle by a credit cycle component.19 shortening the operating cycle, the liquid funds needed for a working capital reserve are, of course, reduced. The theory justifying the reduction is that just as a business requires cash with which to carry it through a normal operating cycle, it receives a benefit by the extension of credit from vendors and suppliers, thereby reducing its need for cash. While at first blush the argument seems plausible, the analysis is flawed when business realities are considered.
The Tax Court’s position would require a corporation in every case to assume it will receive the benefit of credit policies indefinitely, and operate on the “float” extended by its creditors. While the Bardahl formula itself is a fictional analysis, there is no logical reason for a court to go further and thereby presume a “prudent businessman” would base the operating needs of a business on credit policies over which the business has no control. Established precedent, furthermore, is clear that a business may not be forced to turn to borrowing to meet its needs. Instead, the decision not to rely on credit, and to fund expansion through internal means only, lies squarely within the purview of corporate management.20 The Fifth and Tenth circuits have sensibly ruled that it would be unreasonable to require a corporation to rely on credit to reduce its working capital needs unless the corporation or its shareholders have financial or other interests in a vendor or supplier whereby credit terms can be dictated or controlled.21 The Maryland federal district court has also rejected the credit cycle modifier, critically observing such an approach “would keep [the company] one step ahead of the sheriff if everything went right [and] would result in prompt insolvency if everything went wrong.”22 The Tax Court has not followed these rulings to date, and the 11th Circuit does not appear to have ruled on the issue.
The Internal Revenue Service has gone so far as to take the position that the application of the credit cycle can eliminate entirely the need for even $1 of working capital. This extreme example demonstrates that the Commissioner’s credit cycle position defies economic reality. Until a uniform rule is developed, a corporation should be most reluctant to stipulate or agree to a working capital amount which has been reduced by a credit cycle modifier, and should be prepared to refute the application of the credit cycle with appropriate expert witnesses at trial.
Business Plans Requirement
Clearly, the business needs must exist as of the end of the year in issue. Aside from working capital needs, however, virtually all other plans should be documented in a contemporaneous fashion in the corporation’s minutes, in accounting reserves contained in financial statements, or in some other logical business fashion.23 It is not uncommon for corporations to document their needs in a particular year, but then not have any documentation with respect to those plans in subsequent years. Documented business plans are a double-edged sword. If the plans are documented, but thereafter not fulfilled, it may tend to establish that the dedication of funds for such purposes was never justified in the first instance. Funds set aside for specific plans, furthermore, obviously thereby become a source for other business needs when the plans are abandoned. Corporations should review their plans on a periodic basis, updating those plans and abandoning the plans when appropriate, and documenting new plans. In two Tax Court memorandum decisions, Gustafson’s Dairy, Inc. v. Commissioner, T.C. Memo 1997-519 (1997), and Empire Steel Castings v. Commissioner, T.C. Memo 1974-34 (1974), the corporations documented business expansion plans over a five-year period, revising those plans on an annual or other periodic basis as appropriate. The expansion plans, as so documented, were allowed as reasonable business needs, even in those instances in which the plans were not fulfilled as originally projected because of the need to assign priority to other business concerns in subsequent years.
It is possible to prove the existence of a plan without contemporaneous documentation. In the absence of proof of contemporaneous plans, however, it will be difficult for a corporation to meet the specificity requirement of the regulations, although actual expenditures within a short period of time following the end of the year in question can be persuasive to corroborate the existence of undocumented plans.
Overlooked Financial-Related Business Needs
The expansion of the physical plant or a planned acquisition of expensive machinery for the business are obvious examples of business needs in the accumulated earnings tax context, and are given as specific examples in the regulations. Virtually every corporation, however, has other financial needs which, if documented, may support a business need for the retention of corporate funds. Principal among these needs are self-insurance reserves. While authorized by regulations, there is little law on the subject of self-insuring for business purposes. In one case, the mere nonrenewal of an insurance policy itself was found as proof of the plan to self-insure against fire and hazards.24 However, corporations would be well advised to undertake a study of their self-insurance needs and document them in corporate records, rather than rely upon nonrenewed or cancelled policies. If the needs exist, it should be a management decision to fund the needs through the purchase of insurance, to self-insure, or to cover the exposure with a combination of the two. For some hazards, insurance is not available, or not generally purchased within the industry. In such cases, the business need should be readily apparent.25 If insurance would have been an available alternative, however, the Commissioner predictably may oppose any attempt to establish a need to self-insure. The circular but illogical argument goes as follows: If a corporation has exposure to risk, but can cover such exposure with standard priced insurance, a prudent businessperson would pay the premium rather than retain funds to self-insure the risk; the failure to buy insurance, to the Commissioner, becomes proof itself that the exposure does not exist, and thus self-insurance is not a reasonable business need. The absurdity of the argument flies in the face of modern corporate business practice. The only issue should be whether there is an exposure to loss. If so, as the Tax Court in at least one case has ruled, then the decision to self-insure, rather than to purchase insurance, lies within the clear purview of management.26 The Commissioner should not be permitted to make such a fundamental business decision for the corporation. When self-insurance is critical to the corporation’s position, the decision to self-insure should be carefully documented to avoid the claim that there were no definite plans for the years in issue. When possible, the plans should be formulated with the assistance of the corporation’s insurance agency, or with the assistance of professional outside risk experts, including actuaries or other knowledgeable third parties.
The need to retain funds for redemption of stock, particularly in a closely held and family-oriented business, can also justify the retention of earnings in appropriate cases. Often, the corporation already will have documented the stock redemption plan in an agreement among the shareholders and the corporation, yet fail to consider the costs to carry out the plan in calculating its working capital reserves in its annual minutes and financial statements. Caution dictates against an over-reliance on stock redemption needs, however. In many cases, the courts have been hesitant to recognize redemption needs as a future cost to the business, despite the fact it may represent an absolute business debt. Normally debts, including long term debts, justify the need for the retention of money.27 Redemption plans serve a legitimate corporate purpose in establishing business continuity and control. Nevertheless, the courts often appear to be bothered by the personal benefit also derived from such agreements, and tend to lose sight of the fact the redemption serves not only a corporation function, but also a contractual demand against the corporation for cash.28 In the absence of cash with which to buy back its stock when the need to redeem occurs, the corporation will be forced to borrow either from a financial institution or from a selling shareholder, thereby subjecting itself to interest costs, as well as to a predictable future drain on its cash reserves.
Selection of Forum
Traditional considerations are important in selection of the forum for trial of the accumulated earnings tax case, including available precedent. Therefore, in cases not controlled by the precedent in the Fifth and 10th circuits, including most cases tried in Florida which are appealable to the 11th Circuit, the alternative of refund litigation also should be considered when avoiding a credit cycle reduction in the working capital needs of a business is critical to the case.29 When controlling precedent is not a factor, the procedures regarding the burden of proof often favor the Tax Court in a trial of the accumulated earnings tax case.30 motion, the burden of proof can be shifted to the Commissioner with respect to the reasonable needs of the business.31 Admittedly, the procedure to shift the burden in the Tax Court is flawed, because the court continues to struggle in determining whether the pretrial notice is sufficient disclosure of the factual basis of the taxpayer’s position to warrant the shift.32 In many of the reported decisions, the court seems to try the case itself, rather than make preliminary rulings on procedural issues.33 The procedure is flawed also in that the court may not rule on the motion until at or after the calendar call, making trial preparation difficult. Nevertheless, the opportunity to shift the burden should not be ignored since establishing reasonable business needs is virtually conclusive in every case. It may be very difficult for the Commissioner to disprove the asserted business need when the burden has been shifted successfully. There seems to be a reluctance, however, among practitioners to show their hand early in the case. In practice, such concern may not be realistic. The accumulated earnings tax case will go to trial after years of development in audit and appeals. How realistic is it that such critical evidence will not be revealed until trial? District counsel makes extensive use of discovery, and failure to timely articulate its grounds may even prevent the corporation from later raising legitimate issues at trial. The allocation of the burden of proof, while not frequently emphasized by the courts in the decided cases, should not be overlooked by counsel either in selection of the forum or in the presentation of the case at trial.
Conclusion
So long as §531 remains a part of the Tax Code, businesses retaining funds for growth and expansion, or for protection against business contingencies and reversals, remain vulnerable. Documentation of business plans and needs remain an essential business strategy, but also represent a double-edged sword as plans not fulfilled may raise the actual need for the accumulation of funds into question. Business plans should be updated on a periodic basis, as stagnant and unrealistic plans in some cases could be more difficult to defend than even undocumented plans. Payment of adequate dividends is helpful but not alone decisive. In the Technalysis and the Gustafson’s Dairy cases, the accumulations were challenged despite a lengthy history of payment of substantial dividends. In the Technalysis case, a publicly held company which paid some 30 percent of its earnings in current dividends over a period of many years still was forced to defend itself in Tax Court against a challenge from the Commissioner. Furthermore, the Commissioner successfully proved in Technalysis that the corporation’s retained earnings could not be justified by its business needs, and the corporation prevailed only by overcoming the presumption with proof of lack of tax avoidance intent. There was no indicia of intent, and the court’s opinion focuses on the core issue that the retention of funds had always been business motivated, and was not in any way connected to avoidance of shareholder tax.
For corporations unable to justify their accumulations, converting to the “S” corporate form will eliminate the problem for future years. With the healthy business climate and economy, many corporations will have sizeable funds on hand, and seek to retain them for a potential eventual financial downturn. Such a generalized business fear may not be adequate.34 Corporations unable to use the quick fix of the liberalized “S” election rules should make a thorough analysis of business needs prior to year end, placing particular emphasis on the working capital needs of the business. The impact of the credit cycle on the working capital needs of the business should be analyzed. Furthermore, when factors unique to the business are considered by the managers in analyzing its working capital needs, those decisions should be documented in minutes or in some other contemporaneous manner prior to year-end. Otherwise, the Tax Court may apply a rigid Bardahl formula based simply upon balance sheet information.
In virtually all cases, proving the “reasonable needs” of the business represents the key to prevailing in court against the attempted assessment of the accumulated earnings tax. Businesses should pay reasonable compensation for services performed by its shareholder-employees, and avoid the indicia of unreasonable accumulations. doing so, the full attention of the court can be focused on the business requirements and needs of the corporation should it fall under attack by the Commissioner.
q
1 I .R.C. §531. For tax years beginning before 1993, the accumulated earnings tax rate was 28 percent.
2 Generally, the minimum accumulated earnings credit is the excess of $250,000 over the corporation’s accumulated earnings and profits at the end of the preceding tax year. Therefore, if the corporation had no prior years’ accumulated earnings and profits, the minimum accumulated earnings credit would be $250,000. Certain professional service corporations may claim a minimum accumulated earnings credit of only the excess of $150,000 over accumulated earnings and profits at the end of the preceding tax year. I.R.C. §535(c)(2)(B).
3 I.R.C. §1014.
4 Ivan Allen Co. v. United States, 422 U.S. 617, 626 (1975).
5 I.R.C. §532(a).
6 I.R.C. §532(c) provides that the accumulated earnings tax applies without regard to the number of shareholders of a corporation. See also Technalysis Corp. v. Commissioner of Internal Revenue, 101 T.C. 397 (1993), in which excess accumulations were found, but the lack of intent to avoid shareholder taxation was sufficient to avoid accumulated earnings tax liability.
7 I.R.C. §533(a).
8 The §533 presumption is not conclusive. A corporation with an accumulation of earnings in excess of its reasonable business needs may still attempt to prove it was not “formed or availed” of to avoid shareholder tax. Treas. Reg. §1.533-1(b). In Technalysis Corp., 101 T.C. 397, the Tax Court found the intent did not exist, despite excessive accumulations. The court’s opinion, however, is clearly influenced by the publicly held nature of corporation’s stock, in addition to the lack of any objective evidence of intent.
9 Donruss v. U.S., 393 U.S. 297 (1969).
10 I.R.C. §§535(a) and (c).
11 Treas. Reg. §1.537-1(b)(2).
12 Treas. Reg. §1.533-1(a)(2).
13 Treas. Reg. §1.537-2(c).
14 Bardahl Mfg. Corp. v. Commissioner, T.C. Memo 1965-200 (1965).
15 Gustafson’s Dairy, Inc. v. Commissioner, T.C. Memo 1997-519 (1997).
16 Technalysis Corp. v. Commissioner, 101 T.C. 397; John P. Scripps Newspapers v. Commissioner, 44 T.C. 453 (1965). Obviously, salaries should not be unreasonable to the point where they invite disallowance.
17 Bardahl Mfg. Corp., T.C. Memo 1965-200.
18 See Technalysis Corp., 101 T.C. 397.
19 The credit cycle component appears to have originated with the Bardahl companion case, Bardahl International, Inc. v. Commissioner, T.C. Memo 1965-200 (1965), in which the liberalized credit terms extended to the related corporation justified the reduction of the taxpayer’s working capital needs. The credit cycle component has been applied without discussion in numerous Tax Court decisions. See, e.g., Technalysis 101 T.C. 397; W.L. Mead, Inc. v. Commissioner, T.C. Memo 1975-215 (1975), aff’d 551 F.2d 121 (6th Cir. 1977); Delaware Trucking Company, Inc. v. Commissioner, T.C. Memo 1973-29 (1973). Similarly, in J.H. Rutter Rex Mfg. Co., Inc. v. Commissioner, T.C. Memo 1987-296 (1987), the Tax Court applied the credit cycle without discussion or comment, although the case was reversed on appeal by the Fifth Circuit on the credit cycle issue. The Internal Revenue Service Manual instructs agents to apply the credit cycle without exception. I.R. Manual §4233, Exhibit 600-2.
20 J.H. Rutter Rex Mfg. Co., Inc. v. Commissioner, 853 F.2d 1275 (5th Cir. 1988).
21 Id. ; Central Motor Co. v. U.S., 583 F.2d 470 (10th Cir. 1978).
22 Schenuit Rubber Co. v. U.S., 293 F. Supp. 280 (D. Md. 1968).
23 The corporation must have specific, definite, and feasible plans for the use of accumulated earnings. Treas. Reg. §1.537-1(b)(1).
24 Wilcox Manufacturing Co. v. Commissioner, T.C. Memo 1979-92 (1979).
25 Gustafson’s Dairy, T . C. Memo 1997-519.
26 W.L. Mead, T.C. Memo 1975-215.
27 Treas. Reg. §1.537-2(b), lists the retirement of bona fide indebtedness created in connection with the trade or business, in a list of nonexclusive grounds for the accumulation of earnings and profits.
28 Shaw-Walker Co., v. Commission, T.C. Memo 1965-309 (1965), rev’d on other grounds, 390 F.2d 205 (6th Cir. 1968) (redemption needs allowed). In Wilcox, on the other hand, the court found the redemption plans too speculative in nature to justify the retention of earnings, despite the existence of the agreements among unrelated shareholders during the years in issue. The repudiation of the ground as a reasonable business need perhaps can be partially explained by the failure of the corporation to document stock redemption as a need for its accumulations.
29 In cases appealable to the Fifth and 10th circuits, the Tax Court will observe controlling authority within the circuit under its Golsen rule. Golsen v. Commissioner, 54 T.C. 742 (1970), aff’d on other issues, 445 F.2d 985 (10th Cir. 1971).
30 The IRS Restructuring and Reform Act of 1998, which added §7491 to the Code, shifts the burden of proof in many tax proceedings to the Commissioner. The application of the act to §531 cases is not yet clear. See §7491(a)(3). However, the new rules do not apply to corporations with a net worth in excess of $7,000,000, and pre-act law will continue to be relevant for many accumulated earnings tax cases.
31 I.R.C. §534(c); Tax Court Rule 142.
32 See Zeeman Manufacturing Co., Inc. v. Commissioner, T.C. Memo 1997-322 (1997), for a recent case involving a Rule 142 ruling allocating the burden of proof.
33 Gustafson’s Dairy, Inc., v. Commissioner, T.C. Memo 1995-11 (1995); J.H. Rutter Rex, T.C. Memo 1987-296; Motor Fuel Carriers, Inc. v. Commissioner, 59 F.2d 1348 (5th Cir. 1977).
34 J.H. Rutter Rex, T.C. Memo 1987-296. The case is instructive in showing that retooling and retraining in the event of certain contingencies may constitute reasonable business needs, whereas a subsequent history of operating losses were found not relevant as evidence of fear of future business reversals.
John S. Ball is a shareholder in the Jacksonville law firm of Fisher, Tousey, Leas & Ball, where he concentrates in taxation. He is a board certified tax attorney. Mr. Ball received his J.D. from Emory University and an LL.M. in taxation from Georgetown University.
Beverly H. Furtick is a shareholder with the Jacksonville law firm of Fisher, Tousey, Leas & Ball, where she concentrates in estate planning. She is a board certified wills, trusts and estates attorney. Ms. Furtick received her J.D. from the University of South Carolina.
This column is submitted on behalf of the Tax Law Section, J. Bob Humphries, chair, and Michael C. Miller and Lester Law, editors.
