Accumulated Earnings Tax

When comparing the limited liability company (LLC) and the corporation, you'll need to be aware of special tax implications that specifically affect corporations, but not LLCs. One of these issues is the accumulated earning tax.

You may have heard that a corporation can accumulate its earnings: Once it pays tax on them at the corporate level, it need not pay them out as dividends and can thus avoid the second part of the double taxation scheme. This is true with some caveats.

The accumulated earnings tax is a penalty tax imposed on a corporation that is formed or used to help the shareholder's avoid paying income tax by permitting its earnings and profits to accumulate, instead of being distributed. All domestic corporations, other than personal holding companies and tax-exempt corporations, potentially are subject to the accumulated earnings tax.

You can elimination any danger of the accumulated earnings tax, by making a subchapter S election, which results in the corporation being a conduit, passing all earnings through to the shareholders.

Through 2012, there is an "accumulated earnings" tax of 15 percent on earnings that a corporation accumulates above $250,000. (The limit is $150,000 for certain "personal service corporations," which are corporations in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting, where the owners provide the services). This tax does not apply to LLCs.

However, this tax is usually easy to avoid, by using some combination of these strategies:

• Reduce the earnings. Earnings can be reduced to zero, through the withdrawal of earnings in deductible ways such as higher salaries for the owners or by investing in business.
• Establish that the accumulation was "reasonable."The corporation can accumulate earnings beyond these limits, provided it can prove it has a business need to do so, such as payment of anticipated future operating expenses, a planned business expansion, etc.