A Little More About C Corporations and Excess Accumulated Retained Earnings Tax

If a C Corporation goes over the $250,000 accumulated retained earnings cap set by the IRS, those earnings become subject to something called the “excess accumulated retained earnings tax.” This is a tax the federal government set up to make sure that C Corporations distribute profits from time to time.

The government reasoned that C Corporations with retained earnings typically experienced higher stock price appreciation than other C Corporations, making them attractive investments, and one that shareholders wouldn’t be interested in selling any time soon. This wasn’t in the government’s best interest, as its tax revenues would decrease. Shareholders wouldn’t pay taxes until they sold their shares, and even then, their profits would be taxed at the current capital gains rate, which was lower that the rate for personal earned income.

The government determined that if it assessed a tax on retained earnings, sooner or later the corporation would rather put the onus on paying this tax onto its shareholders instead, and if the tax was high enough, even the largest investors wouldn’t be able to persuade a C Corporation not to distribute its profits at some point. And once those profits were distributed, the government could collect capital gains tax from the investors.

A great example of this is Microsoft. In July of 2004, Microsoft had retained earnings of approximately $60 billion and was paying dividends of around $0.16 per share each year. Investors were wondering if they would ever get some serious money out of the business, short of selling their shares. Well, in the July 2004 announcement, Microsoft stated that in December 2004 it would make a one-time dividend payout to its shareholders of about $32 billion, along with doubling its annual dividend rate to $0.32 per share.

Why had Microsoft held out so long? There are many reasons, but one of the most commonly-cited ones was that Bill Gates had held up the dividend payout because of the impact it would have on his taxes. Because of his position as a major shareholder, Mr. Gates had the clout to persuade the directors to hold off on paying out distributions. When they were paid out, Bill Gates received some $3.6 billion and donated the entire amount to charity, offsetting the tax hit he would otherwise have faced on such a huge windfall.

Those are some of the key elements that make up a C Corporation. Now let’s move on to S Corporations.

There are many variables when you’re structuring a business. That’s why it’s hard to go through a quick-service website. Unless you talk to someone who’s got some knowledge and experience on both the tax and the legal side, it’s hard to know what you don’t know. And that can leave you vulnerable.

Got questions? Contact us! We’re here for you.

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