What is Accumulated Earnings Tax?
The accumulated earnings tax is a charge levied on a company's retained earnings. Also called the accumulated profits tax, it is applied when tax authorities determine the cash on hand to be an excessively high amount.
How Does Accumulated Earnings Tax Work?
The accumulated earnings tax, also called the accumulated profits tax, is a tax on abnormally high levels of earnings retained by a company. It compensates for taxes which cannot be levied on dividends.
This tax evolved as shareholders began electing to have companies retain earnings rather than pay them out as dividends, in an effort to avoid high levels of taxation. Historically, this excessive retention of earnings resulted in an increase in the market value of the company's stock. Instead of collecting the dividend payments (and then paying a high tax rate on the added income), shareholders would then net the profit by selling a few shares of their now inflated stock and pay the lower capital gains tax.
Why Does Accumulated Earnings Tax Matter?
While this strategy is great for investors (who end up paying a lower tax rate for the same additional income), it's terrible for the IRS. In this respect, the accumulated revenue tax protects the public sector from not receiving money due on taxable income by encouraging companies to issue dividends rather than just sit on cash.