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To: S100 who wrote (114140)	2/23/2002 6:15:21 PM
From: S100	Respond to of 152472

Corporation Retained Earnings In general, profits that have not been distributed to shareholders are called retained earnings. A corporation is permitted to accumulate earnings for use in expansion or for other bona fide business reasons. However, if a corporation accumulates earnings beyond reasonable needs of the business, it may be subject to an accumulated earnings tax [IRC §531–§537]. The accumulated earnings tax is in addition to the income tax of a corporation. Retained earnings of $250,000 or less ($150,000 or less for personal service corporations) are considered within the reasonable needs of a business. If a corporation accumulates over $250,000 ($150,000 for personal service corporations) without making distributions to its stockholders, it must have a bona fide business reason for doing so. The corporation must be able to show that tax avoidance is not one of the purposes of accumulation. Existence of a tax avoidance purpose will trigger the accumulated earnings tax. Note: There is no line on the tax return to report the accumulated earnings tax. It is a penalty tax applied after an IRS audit determines the corporation is liable. Reasonable Business Needs The regulations under Section 537 provide an analysis of reasonable needs of a corporation. This is not an exclusive list. • Expansion: A corporation can accumulate earnings to provide for bona fide expansion of the business. This includes purchase of new buildings, equipment, or machinery, either to replace old assets or to expand business operations; and the acquisition of another business enterprise by purchasing its stock or assets. • Pay Off Debts: Accumulated earnings may be used to pay off debt created in connection with business operations. • Product Liability Loss Reserves: A corporation can accumulate earnings in anticipation of product liability losses. • Section 303 Redemption Needs: A corporation can accumulate earnings in anticipation of a need to redeem stock of a shareholder who has died. • Supplier Or Customer Needs: A corporation can accumulate earnings to provide for investments or loans to suppliers or customers if necessary to maintain the business of the corporation. • Working Capital: Accumulated earnings may be used to provide a level of necessary working capital for business operations. For example, assume that a supermarket needs $4,000,000 of inventory on hand to operate. The corporation can obtain the inventory by accumulating its earnings. Unreasonable Needs The following are considered unreasonable needs of the corporation. This is not an exclusive list. • To avoid tax on dividend distributions. • To provide loans to shareholders. • To pay expenses for personal benefit of the shareholders. • To provide loans that have no reasonable relation to the conduct of the business. • To provide loans to other corporations that are owned directly or indirectly by the corporation or its shareholders. • To provide funds for investments which are unrelated to the activities of the business. • To provide for unrealistic hazards. "Bardahl Formula" A method commonly used to substantiate reasonable accumulation of earnings by a business is called the "Bardahl Formula." The IRS assessed accumulated earnings tax on Bardahl Manufacturing Corporation. Tax Court held that accumulation of earnings by Bardahl was not unreasonable, and accepted the company’s stated method of computing necessary operating capital. The formula calculates the amount needed to fund inventory by analyzing the average number of days in an operating cycle, average inventory, average accounts receivable, average accounts payable, and then comparing the current working capital needs with actual accumulations of earnings. Appropriated Retained Earnings Account In order to avoid the accumulated earnings tax, the corporate board of directors must discuss the need to accumulate earnings, and the discussion must be reflected in the corporate minutes. The financial statements of the corporation should also reflect the need to accumulate earnings, so the shareholders know that the appropriated amounts are not available for dividends. Corporations commonly accomplish this by setting up an Appropriated Retained Earnings Account. Have a question about our C corporation form 1120 tax software? 1120accountant.com