C Corporation Penalty Taxes – Time To Dust-Off and Review?

Overview

C corporations were all the rage in agriculture in the 1960s and 1970s.  Many farming operations were structured that way in those decades and farmland was placed inside them.  However, with the advent of limited liability companies in the late 1970s in Wyoming and Colorado (and, later, all states) and other unique entity forms, and a change in the tax law in 1986, they became less popular.  2017, however, could be the start of renewed interest in the C corporate form.  A primary driver of what might cause some to reconsider the use of the C corporation is that President-elect Trump campaigned in part on reducing the corporate tax rate.  Similarly, in the summer of 2016, the U.S. House Ways and Means Committee released a proposed “blueprint” for tax reform that also contained a lower corporate tax rate.  If that happens, the use of C corporations may be back in vogue to a greater extent than presently.

If C corporations do gain in popularity, there are a couple of C corporate “penalty” taxes that practitioners need to remember are lurking in the background.  In addition, a recent IRS Chief Counsel Advice (C.C.A. 201653017 (Sept. 8, 2016)) illustrates that the IRS hasn’t forgotten that these penalty taxes exist.  Today’s post takes a look at the basic rules of the accumulated earnings tax and the personal holding company tax – two C corporate penalty taxes that can be problematic. 

Accumulated Earnings Tax

The accumulated earnings (AE) tax is in addition to a corporation's regular income tax. I.R.C. §531.  The AE tax is designed to prevent a corporation from being used to shield its shareholders from the individual income tax through accumulation of earnings and profits, and applies to “accumulated taxable income” of the corporation (taxable income, with certain adjustments.  I.R.C. §535).  There is substantial motivation, even in farm and ranch corporations, not to declare dividends because of their unfavorable tax treatment.  Dividends are taxed twice, once when they are earned by the corporation and again when corporate earnings are distributed as dividends to the shareholders.  This provides a disincentive for agricultural corporations (and other corporations) to make dividend distributions.  Consequently, this leads to a build-up of earnings and profits within the corporation.

The AE tax (at a rate of 20 percent) applies only to amounts unreasonably accumulated during the taxable year.  Indeed, the computation of “accumulated taxable income” is a function of the reasonable needs of the business.  So, the real issue is the extent to which corporate earnings and profits can accumulate before triggering application of the accumulated earnings tax.  To that end, the statute provides for an AE credit which specifies that all corporations are permitted to accumulate earnings and profits of $250,000 without imposition of the tax.  I.R.C. §535(c)(2)(A).  However, the credit operates to ensure that service corporations (fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting) only have $150,000 leeway.  I.R.C. §535(c)(2)(B).  But, remember, not every corporation that exceeds $250,000 (or $150,000) of accumulated earnings and profits will trigger application of the accumulated earnings tax.  That’s because the tax applies only if a particular corporation has accumulated more than $250,000 (or $150,000) in earnings and profits and the accumulation is beyond the reasonable needs of the business. 

Reasonable business needs.  For agricultural corporations, it is important that legitimate business reasons for accumulating earnings and profits in excess of $250,000 be sufficiently documented in annual meeting minutes and other corporate documentation.  IRS regulations concede that some accumulations may be proper, and agricultural corporations should try to base their need for accumulating earnings and profits on the IRS guidelines.  Treas. Reg. §1.537-2(b).  For instance, an acceptable reason for accumulation is to expand the business through the purchase of land, the building of a confinement unit or the acquisition of additional machinery or equipment.  Similarly, earnings and profits may be accumulated to retire debt, hire additional people, provide necessary working capital, or to provide for investments or loans to suppliers or customers in order to keep their business.  Conversely, the IRS specifically targets some accumulations as being improper.  Treas. Reg. §1.537-2(c).  These include loans to shareholders or expenditures of funds for the benefit of shareholders, loans with no reasonable relationship to the business, loans to controlled corporations carrying on a different business, investments unrelated to the business and accumulations for unrealistic hazards.  Thus, while there are many legitimate business reasons for accumulating excess earnings and profits, there are certain illegitimate reasons for excess accumulations which will trigger application of the accumulated earnings tax. 

This all means that it is very important that the corporation's annual meeting minutes document a plan for utilization of accumulated earnings and profits.  For example, in Gustafson's Dairy, Inc. v. Comm'r, T.C. Memo. 1997-519, the AE tax was found not applicable to a fourth-generation dairy operation with one of the largest herds in United States at one location.  The corporation had accumulations of $4.6 million for herd expansion, $1.6 million for pollution control, $8.2 million to purchase equipment and vehicles, $2 million to buy land, $3.3 million to retire a debenture, and $1.1 million to self-insure against loss of herd.  The court found those accumulations to be reasonable particularly because the dairy had specific, definite or feasible plans to use the accumulations, which were documented in corporate records.  Those corporate records (minutes) also showed how the corporation computed its working capital needs.  The key point is that the corporation had a specific plan for the use of corporate earnings and profits, knew its working capital needs, and wasn’t simply trying to avoid tax.

Personal Holding Company (PHC) Tax

The other penalty tax applicable to C corporations is the PHC tax.  I.R.C. §§541-547.  This tax is imposed when the corporation is used as a personal investor.  The PHC tax of 20 percent for tax years after 2012 is levied on undistributed PHC income (taxable income less dividends actually paid, federal taxes paid, excess charitable contributions, and net capital gains).

To be a PHC, two tests must be met.  The first test is an ownership test, and is satisfied if five or fewer people own more than 50 percent of the corporate stock during the last half of the taxable year.  Most farming and ranching operations automatically meet this test.  The second test is an income test and is satisfied if 60 percent or more of the corporation's adjusted ordinary gross income (reduced by production costs) comes from passive investment sources.  See, e.g., Tech. Adv. Memo. 200022001 (Nov. 2, 1991). 

The potential problem of rental income.  Rental income is included in adjusted ordinary gross income unless adjusted rental income is at least 50 percent of adjusted ordinary gross income, and dividends for the taxable year equal or exceed the amount (if any) by which the corporation's non-rent personal holding company income for that year exceeds 10 percent of its ordinary gross income.  In other words, if the mixture of rental income and other passive income sources exceed 10 percent and the rental income exceeds 50 percent, the PHC tax could be triggered.  Thus, farming and ranching corporations engaged predominantly in rental activity may escape application of the PHC tax.  But if the corporation's non-rent personal holding company income (dividends, interests, royalties and annuities) is substantial, the corporation must make taxable dividend distributions to avoid imposition of the PHC tax.  Thus, for corporations owning agricultural land that is cash rented out and the corporation's only passive income source is cash rent, there is no PHC tax problem.

For many farm and ranch corporations, the problem of being a PHC is serious.  A common scenario is for a farmer or rancher to retire with a tenant or child continuing to farm or ranch the land and pay rent.  If the operation has been incorporated, the receipt of rents could cause the corporation to be a PHC.  In this situation, it is critical to have the proper type of lease to avoid imposition of the PHC tax.  For example, in Webster Corporation v. Comr., 25 T.C.55 (1955), the IRS argued that a farm corporation had become a personal holding company.  The IRS lost, but only because the lease was a material participation crop share lease and substantial services were being provided by a farm manager.  The farm manager's activities were imputed to the corporation as land owner.  The court held that income under such a lease was business income and not rental income.  However, if the lease is not a material participation share lease, then the landlord receives rent.  Certainly, fixed cash rents will be treated as rent.  If the corporation receives only rental income, the rents are not PHC income.  But if the corporation also receives other forms of investment income, the rents can be converted into personal holding company income.

In the typical farm or ranch corporation setting, there is usually a mixture of rental income and other passive income sources.  Over time, the corporation typically builds up a balance in the corporate treasury from the rental income and then invests that money which produces income from other passive sources.  As a result, there is, at some point in time, a mixture of rental income and other passive income sources that will eventually trigger application of the personal holding company tax.  For farming and ranching operations structured as multiple entities, this is one of the major reasons why the landholding entity should not be a C corporation.  The only income that a landholding C corporation entity will have initially is rental income.  However, the tendency to invest the buildup of rental income over time will most likely trigger application of the personal holding company tax down the road.

Taxable income

Finally, a limiting factor in both of these taxes is taxable income. If the corporation doesn’t have taxable income, it isn’t accumulating earnings and is not subject to the AE tax. Also, corporations without taxable income are usually not subject to the PHC tax. Use Form 1120, Schedule PH, as a guide.

Conclusion

A more favorable tax climate for C corporations could spawn renewed interest in their formation and usage.  But, remember the penalty taxes that can apply.  The IRS hasn’t forgotten them, as illustrated by that recent Chief Counsel Advice.  That Chief Counsel Advice referenced earlier also points out that that the AE tax can apply even though the corporation is illiquid.  It doesn’t depend on the amount of cash available for distribution.  It’s based on accumulated taxable income and is not based on the corporation’s liquid assets.  In addition, IRS noted, I.R.C. §565 contains consent dividend procedures that a corporation can use to allow the payment of a deemed dividend when a corporation is illiquid.  In any event, both the AE tax and the PHC tax are penalty taxes that will be strictly construed.  There is no wiggle-room.

So, remember the possible penalty taxes and plan accordingly when utilizing a C corporation.