Accumulated Earnings Tax

April 13, 2006

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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.

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.

From 2003 through 2008, the IRS imposes an additional "accumulated earnings" tax of 15 percent (previously set at the highest individual tax rate before enactment of the Jobs and Growth Tax Relief Act of 2003) on earnings a corporation accumulates above $250,000. The limit is $150,000 for certain "personal service corporations" (i.e., 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.

This tax is designed to dissuade corporations from accumulating earnings just to avoid paying taxable dividends. However, this tax is usually easy to avoid, for three reasons:

Earnings can be reduced to zero, through the withdrawal of earnings in deductible ways such as higher salaries for the owners.
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.
The corporation can elect to be treated as a conduit for tax purposes, by making a subchapter S election, which eliminates this problem.