Reducing AE Tax

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Arlington, VA

Editor’s note: This case study has been adapted from PPC Tax Planning Guide—Closely Held Corporations, 17th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, James A. Keller, Gary W. Brown, James J. Mogelnicki and William R. Bischoff, published by Practitioners Publishing Company, Fort Worth, TX, 2004 ((800) 323-8724; www.ppcnet.com).

The accumulated earnings (AE) tax is a penalty imposed by Sec. 531 on corporations for accumulating earnings to avoid income tax at the shareholder level. However, the tax is not assessed if earnings are not accumulated beyond the business’s reasonable needs.

Regs. Sec. 1.537-1(b)(2) states that the reasonableness of anticipated needs is judged on the facts existing at the close of the tax year. This means that subsequent events cannot be used to show that the retention of earnings and profits (E&P) was unreasonable at the close of the tax year, if all the elements of reasonable anticipation are present at that time. For example, an accumulation was not unreasonable when expansion plans were abandoned after a manager/shareholder’s illness; see Sterling Distributors, Inc., 313 F2d 803 (5th Cir. 1963). However, subsequent events may determine whether a taxpayer actually intended to consummate (or has actually consummated) the plans for which it accumulated the E&P. In this regard, projected expansion or investment plans should be viewed in light of the facts during each year and at the close of the year. If a corporation has justified an accumulation for future needs by plans never consummated, it must take this into account in determining whether subsequent accumulations are reasonable.

When to Determine Reasonable Needs

Lobo Grading, Inc. is a C corporation site contractor that uses motor graders and bulldozers to accomplish the majority of its work. Lobo’s revenues have averaged $4.5 million for the past four years; it owns over $1.5 million in equipment.

Due to restrictions, Lobo has been able to finance only about 70% of the equipment’s value. However, in January 2004, it found a lender to finance 100% of all equipment purchases and refinance all existing equipment loans.

Although in the past, Lobo clearly has needed up to $450,000 in accumulated earnings ($1,500,000 x 30%) to afford the equipment necessary to produce revenue, the change in lending policies eliminated that need for capital as a valid reason for accumulating income. Thus, in 2004 and later years, the IRS could impose the AE tax.

Documentation

To avoid an IRS attack, a corporation should identify and quantify its anticipated needs and then thoroughly document them. If the IRS challenges the taxpayer’s position on the AE tax, it will do so several years later. Thus, the IRS will be able to determine whether the corporation followed through with its plans. It will also be able to look at subsequent accumulations and might contend that the need for funds did not arise until a later year. Because the IRS will have the benefit of hindsight, the strength of the taxpayer’s position will depend on how specific its plans are and whether they are well documented.

The corporation needs sufficient facts and documentation to substantiate that future plans require additional funds. Plans that are “vague, unsubstantiated, post-deficiency notice assertions” of business needs are not acceptable; see Northwestern Indiana Telephone, TC Memo 1996-168, aff’d, 127 F3d 643 (7th Cir. 1997), cert. den. Under Regs. Sec. 1.537-2(a), a determination of whether the accumulated E&P is a reasonable business need is based on the circumstances; Regs. Sec. 1.537-2(b) lists the circumstances in which an accumulation of earnings will be deemed reasonable.

In determining whether a corporation can use its plans as a defense against a potential IRS argument that it accumulated E&P to avoid tax, it should ascertain, for each individual need, whether the plan:

1. Qualifies as a reasonably anticipated future need of the corporation’s business.

2. Is a specific plan, rather than a vague generality. In Haffner’s Service Stations, 326 F3d 1 (1st Cir. 2003), the court noted that although the Code does not refer to a specific plan, Regs. Sec. 1.537-1(b)(1) refers to a specific, definite and feasible plan. According to the court, dispensing with formality does not create a license for vague, uncertain or indefinite plans. In determining whether the plan meets this requirement, the details of the plan, including the information used in reaching the decision that the plan is viable, who in the corporation is involved in the plan and how its goals are being accomplished, should be available. If the information appears consistent with prudent business practices, it is likely that the plan would meet this requirement.

3. Is documented. In Otto Candies, 288 FSupp2d 730 (DC LA 2003), a district court held that a group of marine transportation companies was not subject to AE tax, because it was able to establish that its accumulated earnings were reasonable. The taxpayer established this through credible testimony and documents reflecting feasible, cost-specific plans for needs such as fleet replacement, project funding, working capital and redemption of a minority shareholder’s interest. Further, the court rejected the IRS’s argument that the redemption, in itself, reflected a tax avoidance purpose. According to the court, tax avoidance was not otherwise indicated by use of some funds for well-documented and secured shareholder loans or for other questionable items that were either immaterial or ultimately helpful to business growth.

The following are suggested ways for the corporation to meet the documentation requirement:

• It should include in the corporate minutes a discussion of the purpose for which the funds are being accumulated (e.g., plant expansion). It should not refer specifically in the minutes to “accumulated earnings,” because IRS examiners frequently request copies of the minutes as part of routine examinations. Frequent references to accumulated earnings may point to an issue that the IRS examiners might not otherwise raise.
• Shortly after the end of each tax year, it should compile written evidence of the business needs for accumulating funds (i.e., an accumulated earnings plan), including:

1. Definitive and verifiable reasons for the accumulation of funds, including specific projected dates for using them and specific amounts needed for each separate purpose for which E&P is being accumulated; see Gustafson’s Dairy, Inc., TC Memo 1997-519.

2. Copies of items supporting the accumulation, including appraisals, bills for surveying costs and architectural fees, building estimates, site studies and working capital requirement computations, etc., when applicable and feasible.

• The corporation should update the plan annually, by:

1. Revising details on previously identified purposes for the accumulations. The IRS will usually only consider factors existing at the time of the accumulation. It does not matter if circumstances later change and make the accumulation unnecessary, as long as it was reasonable and necessary for the year in question. Thus, the plan can be revised annually without affecting the prior-year’s basis for reasonableness.

2. Identifying in the updated plan all new reasons for accumulations.

The corporation should retain a copy of each year’s plan for a minimum of five years.