What is the Accumulated Earnings Tax (AET) Penalty?

The IRS can impose a 20% accumulated earnings tax (AET) on C corporations that retain too much earnings to avoid issuing taxable dividends to shareholders. The penalty is not tax-deductible, and is in addition to the 21% corporate tax rate for a total tax bill of 41%.

Due to the double taxation character of the C corporation, the benefit of the lower corporate tax rate of 21% can be lost when corporate profits are distributed to individual shareholders as dividends. In the individual tax return the dividends can be taxed at 15 or 20 percent (depending on the “break points” for qualified dividends) and as high as 23.8% if the individual is also subject to the net investment income tax (NIIT).

One way that corporations aim to avoid this double taxation is that the money remains in the corporation so it is only taxed at the corporate rate. All C corporations are permitted to retain a minimum amount of earnings for reasonable needs without being subject to the AET.

The IRS defines “reasonable needs” as funds retained for future business growth, expansion, debt repayment, or other legitimate business needs. If the corporation retains earnings for valid business purposes, such as purchasing inventory, equipment, or expanding operations, these accumulations are generally not subject to the tax.

For C corporations other than personal service corporations, the amount is $250,000, minus accumulated earnings at the close of the preceding year. The credit amount is $150,000 for C corporations whose principal function is performing services in accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, or the performing arts.

If $250,000/$150,000 doesn’t seem like much money, that’s because the limits were established in 1981 and have never been adjusted for inflation. If they were inflation adjusted, as of 2024 they would have to be $853,481/$512,089.

There are various ways a C corporation can reduce its retained earnings to stay within the $250,000/$150,000 limits — for example:

• Pay out dividends (this also helps show lack of intent by the corporation to avoid income tax on its shareholders by accumulating earnings and profits instead of distributing them).
• Increase salaries and bonuses for corporate employees (but employee compensation must be reasonable or it could be recharacterized as a disguised dividend by the IRS).
• Provide more employee fringe benefits, such as a qualified pension plan.

The minimum AET credit benefits new corporations the most, since they have no accumulated earnings from the prior year.