What is an Accumulated Earnings Tax?

The accumulated earnings tax is an additional business tax that is paid by corporations who choose to retain accumulated earnings rather than pay out the earnings in the form of dividends to investors. As a tax on earnings that are to be diverted into settling outstanding debt or investing the some aspect of the company operation, accumulated earnings taxes are calculated in addition to the usual corporate income taxes. However, it is important to remember that the amount of accumulated earnings may impact the total amount of income tax due in a given quarter.

The rationale behind the idea of paying an accumulated earnings tax has to do with the anticipated impact of the report of the accumulated earnings on the stocks issued by the corporation. It should be remembered that since accumulated earnings that are invested back into the company are treated as capital gains rather than dividends, the government would not receive as much in the way of tax revenue. The implementation and collection of the accumulated earnings tax manages to provide a little more tax revenue while still making the option of reinvesting the earnings into the company a viable option.

However, in some cases the accumulated earnings tax may be enough to discourage the action of reinvesting the funds into some portion of the operation. One possible scenario is that investors put pressure on the company to reinvest a large amount of accumulated earnings in some aspect of the business, as a way of preventing the need for the investors to pay dividend taxes. To this end, there is a chance that the government will step in if it appears that an inordinate amount of accumulated earnings are consistently being redirected into the business, rather than being used for dividends on some sort of recurring basis.

A second scenario may have to do with the generation of a small amount of accumulated earnings. For companies that are realizing a very small amount of accumulate earnings each financial period, the bottom line may dictate that the company issue the dividends and thus eliminate having to pay the additional accumulated profits tax that would otherwise apply to the period.

The accumulated earnings tax serves the dual purpose of encouraging companies to pay dividends, as well as minimize the loss in taxes that the government experiences when accumulated earnings are redirected into the corporation. The result of this type of tax is that investors still receive reasonable dividends, companies still occasionally have a windfall to invest back into the business, and the federal government still receives an equitable amount of taxes.