4 You are the chief financial officer for the Insider Corpor

4. You are the chief financial officer for the Insider Corporation. After auditing your tax return, the IRS has determined that your corporation has $2,000,000 in accumulated taxable income and has assessed a $400,000 accumulated earnings tax. Your company is determined to contest this assessment at appeals, and, if necessary in Tax Court. Assuming the calculation of accumulated taxable income is correct, what arguments can you make to defend against the assessment of this tax?

Solution

The issue will be dropped if it is concluded that earnings and profits have not been accumulated beyond reasonable business needs.

So first we need to prove that such accumulation was on the ground of reasonable business needs.

The term \"reasonable needs of the business\" includes the reasonably anticipated future needs of the business.

Bona fide expansion of business or replacement of plant

Acquisition of a business enterprise through purchasing stock or assets

Retirement of bona fide indebtedness created in connection with the trade or business, such as the establishment of a sinking fund for the purpose of retiring bonds issued by the corporation in accordance with obligations incurred on issue

Necessary working capital for the business

Investments or loans to suppliers or customers

SOME OTHER GROUNDS ARE ALSO AVIALABLE

Redemption of stock held by minority stockholders

Need to meet competition

Reserves for various business risks and contingencies such as self-insurance against casualties, potential liability from litigation, and unsettled business conditions

Need to finance pension or profit sharing plans for the employer

Possible loss of principal customer

Need to redeem excess business holdings of shareholders under IRC 4943 Taxes on excess business holdings.

?ACCUMULATION CAN BE DUE TO CONTINGENCIES

Following grounds are also avialable for accumulation of earnings

An actual or potential lawsuit

A possible liability arising out of some contractual obligation

A possible business reversal resulting from the loss of a customer

Accumulations to guard against competition has been justified in some cases

An accumulation to provide funds to finance a self-insurance plan. This includes key men/women, as well as the more common types of risk insurance

Accumulations to provide a retirement plan for employees.

The tax can be avoided if the corporation can show that the accumulation is not to avoid paying dividends, but to prepare and provide for legitimate business reasons such as the expansion of a facility, acquisition of another business, or debt retirement, among other reasons. It is therefore important to document these needs each year, ideally in the minutes of the shareholders’ or directors’ meeting.

The company is also allowed to retain a sufficient amount of earnings to provide working capital to the business as determined by a formula known as the “Bardhal Formula.” This formula takes into account the capital needed for the business by looking at the business operating cycle and the cash needed to operate the business for a taxable year.