Accumulated Earnings Tax Explanation and Case Examples

  • This tax applies to corporations ‘formed or availed of for the purpose of avoiding income tax with respect to its shareholders by permitting E&P to accumulate instead of being divided or distributed’
  • This penalty is not self assessed
  • Does not apply to PHC corporations

The hard thing for the government to decide is when do we decide that a company is trying to avoid paying income tax by not paying dividends?

In Theory: The equity of a corporation should be analyzed for excessive accumulation of earnings

In Practice: In general, the only time excess earnings are an issue is when the corporation has excessive liquid assets- which include unrealized appreciation in liquid assets

United States vs Donruss Co. Case

  • Donruss was a corporation engaged in the manufacture and sale of bubble gum and candy and in the operation of a farm
  • Since 1954, Don B. Wiener has been the sole shareholder
  • From 1955 to 1961, Donruss was profitable increasing its undistributed earnings from $1.0million to $1.7million
  • No loans or other benefits were provided to Wiener other than his salary
  • No investments unrelated to the business were made by the corporation
  • No dividends were declared during the years in question
  • Wiener provided several reasons for accumulating earnings in the corporation: capital and inventory requirements, increasing costs, risks inherent in the business, the general economy, desire to expand, desire to invest in major distributor- which he did by paying $380,000 for 10,000 shares
  • This case was a Supreme Court case- the tax court held for Donruss; the Court of Appeals reversed and remanded for a new trial due to poor instruction- they said that “tax avoidance was the dominant, controlling, or impelling motive” for accumulation and that tax avoidance didn’t have to be the ‘sole’ purpose. The Supreme Court granted certiorari due to conflicts between the circuits and the role of tax avoidance in accumulating earnings

The Issues:

  • Was there an unreasonable accumulation of earnings?
  • What was the purpose for accumulating the earnings?
  • Was tax avoidance a reason?
  • What is the standard for tax avoidance as it relates to unreasonable accumulation of earnings?


  • There is no question that there was an unreasonable accumulation of earnings. The Tax Court held so and neither party challenged this holding
  • The Supreme Court held that tax avoidance must simply be one of what could be many reasons for accumulating earnings beyond the needs of the business
  • As such, arguing that tax avoidance was not the sole purpose or was not the dominant, controlling, or impelling purpose doesn’t matter- if tax avoidance is one of 100 reasons, that’s all that’s required

Ivan Allen Co. v United States Court Case

  • Ivan Allen was a corporation incorporated in 1902 and actively engaged in the business of selling office furniture, equipment, and supplies in Atlanta, GA
  • In 1965 and 1966, the corporation owned various marketable securities- mostly Xerox stock. These stocks were purchases out of the corporations E&P
  • In 1966, the Xerox stock and debentures had a tax basis to the corporation of $130,000 and a FMV of $2,550,000
  • The undistributed earnings of the corporation during this period were approximately $2.3 million
  • The IRS audited the 1965 and 1966 returns and assessed the accumulated earnings tax in the amount of approximately $150,000
  • The courts agreed that if the Xerox assets are considered at their cost, no unreasonable accumulation of earnings has occurred. However, if the Xerox assets are included at their net realizable value- FMV less cost of converting to cash- in the calculation, there has clearly been an unreasonable accumulation of earnings

Issue: For purposes of determining whether or not there has been an unreasonable accumulation of earnings, are the Xerox assets to be considered at their costs or net realizable value?

Holding: Net realizable value

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