What Is an Accumulated Profits Tax?

An accumulated profits tax is an income tax assessment on corporate savings that exceed a certain threshold. Governments expect corporations to distribute the bulk of profits to shareholders in the form of dividends, which allows the government to tax the dividend distributions at the shareholder level. When a corporation retains its profits instead of distributing profits as dividends, it disrupts the government's expected tax revenue. In instances where a corporation accumulates an amount over a certain threshold, the government imposes a special accumulated profits tax to make up for the revenue it is not receiving through dividend distributions.

The corporate income tax structure has a feature commonly referred to as double taxation. Governments actually tax corporate income twice. A corporation files a tax return every year and pays income tax on net income at the corporate rate. It then distributes a portion of that net income, or profits, to shareholders in the form of dividends. The government taxes this money again at the individual level because shareholders must pay taxes on dividends received when filing individual income tax returns.

Corporations and shareholders are always looking for ways to avoid double taxation and decrease their overall tax burden. One of the mechanisms that corporations began to use to minimize the tax obligation was to hold onto profits instead of distributing them as dividends. This would increase the corporation's cash on hand, and would typically have a positive affect on its stock price. Shareholders could then sell their stock and make a profit that way. They would have to pay capital gains tax on the sale, but the tax rate for capital gains is ordinarily much less than the assessment on dividends.

To combat this practice, governments instituted the accumulated profits tax. This tax kicks in when a corporation has an excess of cash on hand that it cannot justify based on an anticipated need. For example, a corporation is allowed to stockpile cash if it expects to have to payout a substantial litigation settlement in the near future, but it cannot horde cash simply to allow its shareholders to avoid paying taxes on dividends. Once the corporate coffers exceed a threshold established by the tax code in its jurisdiction without adequate justification, it must pay the accumulated profits tax on the amount.

There still may be instances where a corporation chooses to pay the accumulated profits tax rather than allow shareholders to be taxed on dividends. The tax code changes periodically in every jurisdiction. Tax rates that apply to dividends, capital gains, and accumulated profits are fluid, and the right course to take to minimize the tax obligation for the corporation and its shareholders must be evaluated on an ongoing basis.