 Hello and welcome to this session in which we will discuss the accumulated earnings tax and the personal holding company tax Both of these topics deals with taxes taxes imposed by the government Why for what purpose? Well The government don't want you to accumulate too much money in a corporation without taking them out Well, why for what purpose? Well, let's historically. Let's take a look at our income tax structure before 2008 Corporation the highest tax rate was 35 percent. So if you're a corporation 35 percent as an individual your tax rate could range from zero up to 39.6 percent. So if you're in the highest tax bracket and when here we're dealing We are we are concerned with the people with the highest tax bracket. It was 39.6 So individuals had incentive to do what to operate as a corporation Pay on their earning 35 percent and obviously don't take the earnings out Why because if you take them out, you'll be taxed again But we're gonna see later that some people might be able to keep those earnings But the point is as a corporation you pay less taxes. The difference was small approximately 5% Now corporate tax rate is guess what corporate tax rate is flat 21% Notice the difference now is approximately 16% so now Individuals they have every incentive to do what operate as a corporation and never takes the money out. Why because they can Pay they will pay only 21% and as long as they don't take it out. They don't have to pay taxes on dividend So as a result of this as a result of this situation Affluent individual and rich people simply put may consider utilizing the corporate Structure as a way to do what to reduce their tax obligation. So what did the government do it in response? Hold on a second. We know you're up to this We're gonna impose on you the accumulated earnings tax or the personal holding company tax So this is what we're gonna be discussing in this session. Now, you might be saying hold on a second Well, the company pays 21% how about when the owner takes the money out aren't we subject to double taxation? Well, let's talk about double taxation Before we proceed any further, I have a public announcement about my company farhat lectures comm Farhat accounting lectures is a supplemental educational tool That's gonna help you with your CPA exam preparation as well as your accounting courses My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles My accounting courses are aligned with your accounting courses broken down by chapter and topics My resources consist of Lectures multiple choice questions through false questions as well as exercises. Go ahead start your free trial today so When the owner takes the money out, they have to pay taxes again But do owners have to take the money out? They don't have to the owners of the corporation They don't have to take the money out. What can they do? They can keep it They can defer the earnings. So hold on a second. So they make the profit They keep it in the company and they will never take it out. That does not make any sense Well for one thing the longer they keep it The more they save because the longer they keep it the longer they defer for paying taxes because of the time value of money So if you make a hundred thousand dollar today and keep it in the corporation, don't take it out Well, you're saving taxes now because you don't have to take it out So in the future you have savings by not paying taxes. That's one reason Also, as you keep your money in the corporation itself The value of the corporation goes up if you have the if the company is is worth more The stock value is worth more And guess what all in all here's what some people would even go as far as what don't take it out And when they die when they pass away, we're all gonna die. We're all gonna pass away at some point The shareholder passes away with an appreciated stock Remember they kept the money in the company and as a result the stock price went up Now when their kids when their children Take that Inherent this inherent the stock they inherent the stock as a step-up basis. It means they inherent appreciated Stock to avoid income taxation because you will take the fair market value which which is high So the individual drove the stock price stock price up high passed away Passed the stock price High stock price of their kids. That's already appreciated and you don't pay taxes on that transfer Why not? okay Also, we're going to learn later about the state Exclusion, well, it's in the millions of dollars So what you do is you pass those assets to your kids and they're executed from paying State taxes so for all these reasons there's a reason for the government to impose certain taxes Certain taxes to do what to get their money now rather than Letting you keep in it for later Okay, so by accumulated earnings within a corporation and subsequently transferring the stock upon that Double taxation can be entirely avoided and this is what the government fear the most where you keep it You keep paying every year 21% on your earnings never take it out to be double tax because if you take it out You'll have to pay, you know taxes on the dividend. You don't take it out You keep it. So what did the government do? Well, the government came with those two taxes that we need to discuss Which is one is called accumulated earnings tax and the other one called personal holding company So what happened is we're gonna we're gonna make you pay taxes on your retained Undistributed income simply put retained earnings now if you don't know what retained earnings is Let me real quick show you what we are talking about here So when the company generate a profit when the company generate revenues first They incur expenses as a result they They generate net income or net profit Initially the profit is sparked into retained earnings Basically we're keeping the earnings which is undistributed income And at some point if we want to distribute the earning we can if we if you don't want to keep it We can distribute some of the earning as dividend But what the government is fearing you never you never distributed as dividend to be taxed You keep it in retained earnings That's the reason so what happened the government says look you keep too much in retained earnings and undistributed profit You are subject to the either accumulated earnings tax or personal holding company tax. There is no way around it So let's talk about the accumulated earnings tax first. How does it work? Well The company is going to impose a 20 percent on corporate earnings that are accumulated without a valid business reason Simply put if you're accumulating too much money too much money means too much earnings And you're not distributing this earning. Well, we're going to tax you now the burden of proving Providing that you have a reason to keep this money lies with you So if you have a reason to keep the money Well valid reason then you have to show it to the irs. You say look I I should not be paying taxes because x y z And you have to show it you have to prove it So here's what happened businesses can offset this tax with a minimum credit of 250 So simply put you can keep 250 000 in In retained earnings under under distributed profit if you're a service corporation 150 So that's fine. So they're saying this is how much you can keep if you want to keep more You have to have a business legitimate reason earnings beyond the minimum credit You have to have a reason what are what could be some reasons for the company to keep additional earnings? Well, I want to expand business expansion Well, I have a plan to replace my assets I need it for working capital working capital needs to operate my business on a day-to-day basis I might have a lawsuit for product liability loss. I need to pay my debt Self insurance reasonable amount of self insurance cannot say well I need this money to insure myself against losses a reasonable amount Loans to suppliers and customers if you need that money for those reasons Those are considered what we called legitimate legitimate purpose. So you can keep it. However If you are if the IRS will ask you you have to prove it However loans to shareholders if you say I'm gonna keep this money because I'm gonna need some extra money to loan to my owners You can't do that unrelated property business investment. So you want to buy investment? That's unrelated to your business I'm sorry. You can't do that unrealistic hazards Slash contingencies that are not considered valid business needs. You'd say, you know what? I might have a fire next year and as a result I'm gonna have losses You can't do that, right? Or I'm gonna have a lawsuit. You cannot have those unrealistic contingencies What what what can you do to kind of get the government off your back? Distribute the money in dividend or Pay the tax either pay the tax or this distributed in dividend because if you distribute an individend The individend well the owners have to pay taxes now once you do pay the taxes on it It's no longer taxable when you distribute it because the tax was already paid Okay, this is what you have to do. So this is the accumulated earnings tax Let's talk about another similar tax personal holding company tax. What is this? Purpose of this tax well to discourage individuals With high marginal tax rates Aka rich individual from using corporation to shield Certain type of passive income. What does that mean? It means If you have a lot of money a rich individual what you will do you will take your money And that money especially if it's coming from passive income And you will create a corporation and you put that money in the corporation itself And the corporation would create the profit and now The corporation is generating the profit. Therefore the profit is being taxed on a corporate level, which is how much? 21% and you will keep it there and we'll have the same story as the That rich individual on the prior slide until they die Then the asset is passed to their hairs and they will avoid paying any Double taxation. So that's the whole purpose So the personal holding company Was initially targeting what they called incorporated Pocket books. Who are they people who are in the entertainment industry construction industry? The tax aim the purpose of this tax is where individual place the securities securities means stocks bonds in a corporation Allowing the stock to appreciate without paying the rate. That's how it works. Now Similar to the accumulated earnings tax the personal holding company tax also applies 20% To the what to compel you to do what distribute the earnings to shareholders Why because once you distributed you have to pay the tax Simply put the government wants their tax now If you want to keep it you can keep it if you choose pay us the tax or pay it So the individual who gets the money pay the taxes someone will have to pay the tax Now can both taxes be imposed at the same time? Well, no the IRS cannot enforce both taxes the personal holding company tax And the accumulated earnings tax in the same year to be subject to the personal holding company tax The company must meet certain criteria personal holding company specific criteria One more than 50% of the outstanding stocks Must be owned by five or fewer individual So more than 50% of the company is owned by five or less individuals a small group of people And specifically during the latter half of the year the last six months of the year and plus So we're talking about Small group of people owning the company and and notice the end 60% of the income for that corporation is coming from passive sources What is passive sources you own stocks stocks pay you dividend you own bonds bonds pay you dividend Interest i'm sorry you you have you have buildings office buildings rents royalties Or special personal service income like accountant lawyers doctors where the person is involved If that's the case you are a personal holding company and therefore you are subject to that tax Well, how can you eliminate the stocks? Well easy Either distribute the money Or pay the tax just like the accumulated earnings tax The person holding company tax can be diminished or emulated by Distributing the dividend just distribute the money. That's what they want. Why because they want The receiver of that money to pay the taxes. You cannot shield You cannot keep that money And defer paying taxes on it or even avoid Theoretically you can avoid if you wait long enough if you can afford to wait long enough Avoid paying taxes to the government the government wants their money And that's the main reason for the accumulated earnings tax and the personal holding company tax You can't avoid taxes. You gotta pay them What should you do now go to far hat lectures look at additional lectures mcqs through false That's gonna help you whether you are an accounting student cpa candidate or an enrolled agent Accounting and the cpa is important in your career Invest in yourself. Good luck and stay safe You