Chapter 3.PHC and

Accumulated Earnings Tax

Edited January 10, 2014

Howard Godfrey, Ph.D., CPAProfessor of AccountingCopyright Howard Godfrey, 2014

C14-Chp-03-1B-PHC-and-Accum-Earn-Tax-2014

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The student should be able to:

1. Explain why we have a penalty tax on accumulated earnings. Pg-28

2. Determine whether a corporation is liable for the accumulated earnings tax. Pg-28

3. Calculate the amount of the corporation's accumulated earnings tax. Pg-28

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4. Determine whether a corporation is a personal holding company (PHC). Pg-29

5. Calculate the corporation's PHC tax. Pg-29

6. Explain how a corporation can avoid the personal holding company tax. Pg-29

7. Explain how a corporation can avoid the accumulated earnings tax.

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Highlights of Recent Tax Law Changes

The accumulated earnings tax rate was decreased beginning in 2002 due to the decrease in the highest marginal individual tax rate. The tax rate now is tied to the highest rate for a dividend which is now 20%.

The 20% rate also applies to

Personal Holding Companies.

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1. Introduction to penalty taxes.

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Impact of Corporate Motive -1Which of the following taxes is affected by the motives of management for its decisions regarding dividend policy?a. Alternative Minimum Taxb. Accumulated Earnings Taxc. Personal Holding Company Taxd. All of thesee. None of these

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Impact of Corporate Motive -2

Which of the following taxes is affected by the motives of management for its decisions regarding dividend policy?

b. Accumulated Earnings Tax

§532

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Liable for Both? 1 of 2

May a corporation be subject to both the PHC and the accumulated earnings tax in the same year?

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Liable for Both? 2 of 2

May a corporation be subject to both the PHC and the accumulated earnings tax in the same year? No. §532(b)

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2. Determine whether a

corporation is liable for the accumulated earnings tax.

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Accumulated Earnings Tax

The IRS is auditing a particular year and finds that the company has been unreasonably accumulating earnings for the tax year under audit, and in many years prior to the year under audit, as well.

How is the accumulated earnings tax applied?

For all years? For year under audit?

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Accumulated Earnings TaxThe accumulated earnings tax does not apply to:a. Corporations that have more than

100 stockholders. b. S Corporations. c. Corporations filing consolidated returns. d. Corporations that have more than one class of stock. [CPA - May, 1988]

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Accumulated Earnings TaxThe accumulated earnings tax does not apply to:

b. S Corporations. §1362(a)S corporation not subject to taxes imposed under this chapter:[Chapter 1 – Normal taxes and surtaxes (§§1-1400s)]

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3. Calculate the amount

of the corporation's accumulated earnings tax.

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Accumulated Earnings TaxThe accumulated earnings tax is a penalty tax assessed on corporations that accumulate income beyond the reasonable needs of their business. An exemption of $250,000 of accumulated earnings is permitted during the corporation's lifetime. Exemption limited to $150,000 in the case of certain service corporations.§535( c)(2)

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Accumulated Earnings Tax (AET)Corporations Subject to the Penalty Tax. AET applies to every corporation used to avoid the income tax on shareholders by accumulating earnings instead of paying dividends. Personal holding companies & S corporations are exempt from this tax.In theory, the penalty tax applies to all corporations. In practice, the tax applies to closely-held corporations where management can utilize the corporate dividend policy to reduce the tax liability of the shareholder group.

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Accumulated Earnings TaxProving a Tax-Avoidance Purpose. The accumulation of earnings and profits beyond the reasonable needs of the business indicates a tax avoidance motive unless the corporation can prove that earnings are not being accumulated to avoid taxes. Tax avoidance is indicated, for example, where there are loans made between the shareholders and the corporation, investments are made that have no clear connection with the business, or where there is a low dividend and wage payout accompanied by an accumulation of earnings. Holding and investment companies are held to a stricter standard than are operating companies.

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Evidence Concerning the Reasonableness of an Earnings Accumulation. No single factor has been held to be indicative of an unreasonable accumulation of earnings and profits. A discussion of some of these factors follows:

1.Evidence of a Tax-Avoidance Motive. Certain factors should be avoided in order to minimize exposure to the accumulated earnings tax.

2.Evidence of Reasonable Business Needs. Reasonable business needs include reasonably anticipated needs of the business, Sec. 303 redemption needs, and excess business holdings redemption needs. In order to show reasonable business needs, there must be a specific, definite, and feasible plan for the use of accumulations.

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Bardahl formula used for determining working capital requirements. The tax is levied at a 20% rate. The tax base can be reduced by making dividend distributions. Once the IRS or the courts have determined that the accumulated earnings tax is owed, its payment cannot be avoided by deficiency dividends.

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1. Accumulated Taxable Income. Starting point for accumulated taxable income calculation is taxable income. Positive and negative adjustments are made to convert taxable income into a better measure of income retained by the business.

2. Dividends-Paid Deduction. Dividends-paid deduction for 4 types of distributions: (1) dividends paid during the tax year, (2) throwback dividends, (3) consent dividends and (4) liquidating distributions. No dividend carryover is available.

Accumulated Earnings Credit. The accumulated earnings credit does not offset the accumulated earnings tax liability on a dollar-for-dollar basis. It serves to reduce the accumulated taxable income amount (so it is really a deduction). Different rules apply for operating companies, service companies, and holding or investment companies. Accumulated E&P balance used in computing the credit is reduced by the amount of any throwback distributions paid during current year that are considered to have been paid out of preceding year's E&P.

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Build reported for the year:

Div. income (< 20% owned) $30,000

Taxable income 450,000

Federal income tax 153,000

Dividends paid in the year 119,000

Accumulated earnings credit 13,000

What is Accumulated Taxable Income?

Build (Const. Co.) not PHC. Slide 1 of 3

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Taxable income $450,000Div. received deductionFed. income tax liabilityDividends paid Accum. Earnings CreditAccum. taxable incomeAccum. earnings tax rateAccumulated earnings tax

Unreasonable Accum. of Earn. (2 of 3)

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Taxable income $450,000Div. received deduction 21,000 Fed. income tax liability (153,000) Dividends paid (119,000) Accum. Earnings Credit (13,000) Accum. taxable income $186,000Accum. earnings tax rate 20%Accumulated earnings tax $37,200

Unreasonable Accum. of Earn. (3 of 3)

The next 4 slides show the computations in more detail. Note that the penalty is applied when the company could have paid dividends, but chose not to do so. The “10% of Taxable Income” limit on charitable contribution deductions does not apply – the cash is gone – not available for dividends.If you fully deduct a charitable contribution, you do not need (or get) a carryover.

Taxable Income $500,000Federal Income Tax (34%) 170,000 The income above included:Long-term capital gains 30,000 Short-term capital gains 10,000 Div. from 21% owned domestic corp. 100,000 Excess charitable contributions from 2011, deducted in current year. 25,000 Dividends paid in 2014 75,000

Does Corp. owe the accumulated earnings tax?

Manufacturing Corp. is owned by Ms. Smith.Corp. reported the following results for 2014.

E&P balance at start of year was $125,000. Company needs to retain $90,000 this year.

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1 Taxable Income $ 500,000

2 + Dividends received deduct. 80,000 + Net Operating loss ded. (172)+ Capital loss carryover+ Contribution carryover 25,000 105,000

Subtotal 605,000 - Income Taxes 170,000 - Excess Charitable Cont.- Capital loss deduct.-Limited- Net L. T. Capital Gains 30,000

Less related taxes (10,200)Subtotal (189,800)

3 = 415,200 Adjusted Taxable Income

ACCUMULATED EARNINGS TAX - 1 of 3

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3 = Adj. Taxable Income 415,200

- Less: Dividends Paid 75,000

- Less: Credit ( Below ) 125,000 (200,000)

4 = Accum. Taxable Income 215,200

X Tax Rate 20%

5 = Accum. Earnings Tax $ 43,040

ACCUMULATED EARNINGS TAX - 2 of 3

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A + Min. Credit - $250,000 … 250,000 B - Less: Begin. E. & P. 125,000

C = Minimum Credit 125,000

Needs-Based CreditD + Needs: Cap. assets, etcE + Needs: Working CapitalF = Reasonable Needs 90,000 G - Less: Capital Gains… (19,800)

H = Needs Based Credit 70,200

Compute E & P Credit

ACCUMULATED EARNINGS TAX - 3 of 3

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4. Determine whether a

corporation is a personal holding company (PHC).

Individual's Salary $225,000Item. Deduct. & Exempt. (25,000) Dividend Income 100,000 Taxable Income $300,000Tax Rate (OLD RATE) 35.00%Tax on the Div. Income $35,000Idea-Put stock in a Corp.Corporate div. income $100,000Less: Div. Received Ded. (70,000) Taxable Income $30,000Tax at rate of 15% $4,500

Personal Holding Company Rules

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Note: the previous slide illustrates how much tax could be saved by placing dividend-paying stock in a personal holding company rather than owning the stock directly.

The recent reductions in individual income tax rates made the savings smaller.

The PHC rules prohibit this saving.

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Personal Holding Company Tax - 1The personal holding company taxa. Qualifies as a tax credit that may be used

by partners or stockholders to reduce their individual income taxes.

b. May be imposed on both corporations and partnerships.

c. Should be self-assessed by filing a separate schedule with the regular tax return.

d. May be imposed regardless of the number of equal stockholders in a corporation. CPA May-88

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Personal Holding Company Tax - 2

The personal holding company taxc. Should be self-assessed by filing a

separate schedule with the regular tax return.

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Personal Holding Company Tax.A closely-held corporation that satisfies both the stock ownership test and the passive income test is classified as a personal holding company for the tax year. A penalty tax is imposed to prevent taxpayers from using closely-held corporations to shelter passive income. A PHC must pay the greater of the regular corporate income tax or the corporate alternative minimum tax and possibly the PHC penalty tax.

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Personal Holding Company (PHC) Defined.

A PHC is a corp. with five or fewer individual shareholders who own more than 50% of the outstanding stock at any time during the last half of its tax year, and has PHC income (PHCI) that is at least 60% of its adjusted ordinary gross income (AOGI) for the tax year. Corporations that retain special tax status generally are excluded from the PHC definition. Among those excluded are S corporations and tax-exempt organizations.

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Personal Holding Company Tax.

Stock Ownership Requirement.

A corporation satisfies the PHC stock ownership requirement if more than 50% of the value of its outstanding stock is directly or indirectly owned by five or fewer individuals at any time during the last half of its tax year.

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PHC-Passive Income Requirement. A closely held corporation must also satisfy the passive income test to be classified a PHC. The passive income test is met if at least 60% of the closely held corporation's adjusted ordinary gross income (AOGI) for the tax year is personal holding company income (PHCI).1. Adjusted Ordinary Gross Income. For most corporations AOGI equals the corporation's gross income minus its Sec. 1231 and capital gains, and interest, property taxes and depreciation connected with its rental income.

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PHC Income Defined. PHCI includes 12 categories of income.

Special exclusions apply to these types of income.

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Personal Holding Company Tax.Adjusted income from rents (AIR) is included in PHCI unless the special exception applies for a corporation whose earnings are predominantly rental income. PHCI does not include rents if (1) AIR is at least 50% of AOGI and (2) the dividends-paid deduction equals or exceeds the amount by which nonrental PHCI exceeds 10% of OGI. Income earned from personal services contracts is included in PHCI if the two special conditions listed.

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Calculating the Undistributed Personal Holding Company Income (UPHCI) Amount. A series of adjustments must be made to taxable income to arrive at UPHCI. These adjustments attempt to convert taxable income into a better measure of income retained by the business. In addition, a dividends-paid deduction can be claimed for cash and noncash dividends paid during the year plus consent dividends.

2. Calculating the Tax. The PHC tax is 20% times the UPCHI amount.

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Avoiding the PHC Tax Liability - Dividend Distributions. Consent dividends are hypothetical dividends deemed paid to shareholders on last day of the corporation's tax year. Consent dividends permit a corporation to reduce its PHC tax liability when it is prevented from making an actual distribution due to a lack of money. In addition to consent dividends, 5 different types of actual cash or property dividends qualify for the dividends-paid deduction.

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Avoiding the PHC Tax Liability -Dividend Distributions.

1.Current Year Dividends. A dividends-paid deduction, however, is not available for preferential dividends. Dividends are preferential when the amount distributed to a shareholder exceeds his ratable share of the distribution or the amount received by a class of stock is more or less than its rightful amount.

2.Throwback Dividends. Throwback dividends are distributions paid in the first 2 months after the close of the tax year. Subject to a dollar limitation (i.e., 20% of dividends other than cash dividends paid during the year), an election may be made to treat these dividends as a dividend distribution made in the prior year for PHC tax purposes.

Avoiding PHC Tax - Dividend Distributions. 3.Liquidating Dividends. A dividends-paid

deduction is available for liquidating distributions that are made by a PHC within 24 months of the adoption of a plan of liquidation.

4.Deficiency Dividends. A corporation that owes the PHC penalty tax can avoid this tax by electing to pay a deficiency dividend under Sec. 547. An income tax is levied on the dividend payment at the shareholder level instead of the payment of the PHC tax at the corporate level. The shareholders include the deficiency dividend in their gross income for the tax year in which it is received, not the tax year in which the PHC claims a dividends-paid deduction.

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Avoiding PHC Tax - Dividend Distributions.

5. Dividends Carryover. In addition, dividends that are paid in the preceding two tax years can be used as a dividend carryover to reduce the amount of the current year's PHC tax liability. The amount by which dividends eligible for the dividends-paid deduction exceeds UPHCI income for the two preceding years can be carried forward and claimed as a dividends-paid deduction in the current year.

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Cromwell InvestorsCromwell Investors, Inc., has ten unrelatedequal stockholders.Cromwell's income and expenses for the current year: Dividends from-domestic taxable corps $10,000 Interest earned on notes receivable $6,000 Net rental income $3,000 Deductible expenses totaled $4,000No dividends were paid this year. Cromwell's liability for PHC will be based on undistributed PHC income of:a. $0 b. $3,500 c. $6,500 d. $15,000

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Cromwell InvestorsCromwell Investors, Inc., has ten unrelated equal stockholders.

No group of 5 can possibly own over 50%.§542(a)(2)

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5. Calculate the corporation's PHC tax.

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Tests to see if corp. is a PHC:1. More than 50% of the value of

stock is owned by 5 or fewer individuals during the last half of the year

2. Personal holding company income is at least 60% of adjusted ordinary gross income.

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• Once classified as a PHC, the tax base must be calculated–Penalty tax rate = 20%–Tax base is undistributed

Personal Holding Company income (UPHC income)• Amount is taxable income plus or minus certain adjustments, minus the dividends paid deduction

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PHC-ComputationsA PHC has taxable income is $300,000 and a regular federal income tax liability of $100,250. Company claims a $25,000 dividends‑received deduction and pays dividends of $19,000. The PHC tax isa. $80,448. b. $62,930. c. $57,610. d. $41,150. e. None of these.

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Taxable income $300,000

Fed. income tax liability

Div. received deduction

Dividends paid deduct.

Undistributed PHC income

PHC tax rate

PHC tax

Personal Holding Tax. Pg. 3-27

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Taxable income $300,000

Fed. income tax liability (100,250)

Div. received deduction 25,000

Dividends paid deduct. (19,000)

Undistributed PHC income $205,750

PHC tax rate 20%

PHC tax $41,150

Personal Holding Tax. Pg. 3-29

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6. Explain how a

corporation can avoid the personal holding company tax.

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Five ways to avoid the PHC tax. 1. Change Corporation's Stock Ownership.

Additional stock can be sold to unrelated parties in order to avoid having five or fewer shareholders owning more than 50% (in value) of the outstanding stock at any time during the last half of the year.

2. Change Amount and Type of Income Earned by Corporation. Tax-planning options are available including adding additional operating activities, changing the type of investment income earned, or adding additional passive income. These are discussed on p. C5-36

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Five ways to avoid the PHC tax.3.Making Dividend Distributions. Dividends

reduce the tax base used to levy the PHC tax. The inclusion in PHCI of certain income forms (e.g., adjusted income from rents) can be avoided by paying enough dividends to reduce the amount of other PHCI to below the maximum acceptable level. Some of these dividends can be paid after year-end (e.g., throwback or consent dividends) in order to engage in last-minute tax planning.

4.Making an S Election. S corporations are statutorily exempt from the tax. An S election is less attractive because the individual tax rates are now generally above the corporate tax rates, but may avoid double taxation of corporate earnings that are distributed as dividends.

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Five ways to avoid the PHC tax.

5. Liquidate the Corporation. A PHC

can be liquidated and the assets

held by the shareholders.

The liquidating distributions are

eligible for the dividends-paid

deduction and can reduce the

UPHCI amount.

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7. Explain how a corporation can avoid the accumulated earnings tax.

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Avoid Accumulated Earnings Tax. The primary defense against the IRS is to document that the earnings accumulations are necessary to meet future needs of the business. Plans must be documented each year. They should be as specific as possible and be revised periodically. Completed projects must be documented and abandoned projects deleted from the plan.

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Avoid Accumulated Earnings Tax.A current timetable is also desirable. Transactions that are indicative of unreasonable accumulations of earnings should be avoided. Corporations with potential accum. earnings problems may consider making an S election to eliminate accumulated earnings tax problems on a prospective basis.

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Big Corp – Accum. Earnings Tax - 1

Big Corp. has 1,000,000 shares of stock trading at $100 per share. How will it treat a distribution of a 10% stock dividend (current value of stock distributed is $10,000,000) for financial accounting purposes? How does it affect retained earnings?

Does this transaction reduce earnings and profits. See Sec. 312(d).

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Big Corp – Accum. Earnings Tax - 2

Big Corp. has 1,000,000 shares of stock trading at $100 per share. How will it treat a distribution of a 10% stock dividend (current value of stock distributed is $10,000,000) for financial accounting purposes? How does it affect retained earnings? [Reduce]

Does this transaction reduce earnings and profits. See Sec. 312(d). [No]

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Corp. Penalty Taxes-Prob. -1Which of the following taxes is self assessed and paid when the annual corporate tax return is filed?

a. Accumulated Earnings Tax

b. Personal Holding Company Tax

c. Both d. None

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Corp. Penalty Taxes-Prob. -2Which of the following taxes is self assessed and paid when the annual corporate tax return is filed?

b. Personal Holding Company Tax

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Accum. Earnings Credit-1

Is the accumulated earnings credit:

a. A tax credit, or

b. A deduction?

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Accum. Earnings Credit -2

Is the accumulated earnings credit:

a. A tax credit, or

b. A deduction?

It is a deduction.

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Income & Stock Tests-1Which of these taxes involve an income test and a stock ownership test?a. Accum. Earnings Taxb. PHCc. Both d. Neither

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Income & Stock Tests-2Which of these taxes involve an income test and a stock ownership test?a. Accum. Earnings Taxb. PHCc. Both d. Neither

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Compliance ConsiderationsPersonal Holding Company Tax. A PHC must file a corporate income tax return Form 1120 including a Schedule PH. The statute of limitations is extended from three to six years if a PHC fails to file the Schedule PH, even though no additional tax may be due. The payment of deficiency dividends eliminates the additional tax that is owed, but does not prevent the corporation from having to pay interest and penalties if the PHC penalty tax is paid after the due date for filing the return.

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Compliance ConsiderationsAccumulated Earnings Tax. No formal schedule is required for the accumulated earnings tax. Interest is charged on any tax owed from the date the return is originally due to the receipt of payment. The penalty for negligent underpayment of taxes may be assessed in accumulated earnings tax situations.

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Acc. Earn. Credit - §535

• A corp. is a manufacturer with beginning E&P of $120,000 and current E & P of $140,000. What is its minimum credit?

• Suppose the corp. can justify an accumulation of $200,000.What is the accum. earnings credit? (See next slide) 1.535-3

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Minimum Credit Case 1 Case 2

Reasonable needs $200,000

Min. Tax Credit $250,000

Accum. E & P - Beg.

Potential Credit

Credit is greater of (1) or (2).

Assumes the "reasonable needs"

are total needs --not just the need for

additional accumulation this year.

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Minimum Credit Case 1 Case 2

Reasonable needs $200,000

Min. Tax Credit $250,000

Accum. E & P - Beg. $120,000 $120,000

Potential Credit $80,000 $130,000

Credit is greater of (1) or (2).

Assumes the "reasonable needs"

are total needs --not just the need for

additional accumulation this year.

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The

End