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TAX CLINIC

for a valid business purpose. Ideally, a of year 1, it had $100 of accumulated investments are connected to its busi-
corporation should contemporaneously earnings, $40 of which will be paid ness needs.
document its intended use of accumu- as a dividend. Using the Bardahl for-
lated earnings instead of waiting until mula, X estimated it will cost $25 Example 3: Each year, X invests a
the IRS raises the issue in an examina- cash to complete an operating cycle. portion of earnings in a combination
tion (e.g., through a budget or similar In its budget, X set aside $35 of cash of bonds and equities. Per its invest-
business plan). to finance acquisitions it is actively ment policy, X makes these invest-
First, a corporation should determine investigating. If the IRS inquires ments in order to protect its earnings
how much cash (or working capital) it about X’s accumulation of earnings against inflation, fund its employee
needs to operate its business. One ap- in an examination, X’s contempora- compensation plan, and generate the
proach, known as the Bardahl formula, neous documentation can demon- capital it needs to expand its business
is to calculate the costs of running strate that it had specific, definite, into similar product lines. X’s con-
the business for one operating cycle and feasible plans for the use of the temporaneous documentation con-
(see Bardahl Manufacturing Corp., T.C. $100 of accumulated earnings either necting how its investments relate to
Memo. 1965-200; Bardahl International in its business or to pay dividends. its business would tend to mitigate
Corp., T.C. Memo. 1966-182). Broadly an argument that it was avoiding
speaking, the corporation calculates If a profitable corporation accumu- paying dividends to shareholders.
the time, expressed as a percentage of lates earnings beyond the reasonable
a year, needed to complete one operat- needs of its business, it may need to Loans to and expenditures on
ing cycle (e.g., to produce inventory, consider paying dividends to its share- behalf of shareholders
effect sales, collect from customers). holders. Otherwise, the IRS could argue A nondividend payment by a corpora-
It then multiplies this percentage by the corporation has a purpose to avoid tion out of its surplus earnings may
its total operating costs for the year shareholder-level tax. A corporation is be viewed by the IRS as evidence of a
to arrive at an estimate of its operat- well served by outlining a policy or doc- purpose to avoid shareholder-level in-
ing costs for one cycle. The result, an umenting a plan for paying dividends. come tax. Personal loans to shareholders
estimate of its working capital needs, or payment of a shareholder’s personal
is then compared to its accumulated Example 2: X is a successful busi- expenses could suggest an intent to
earnings balance at year end. The IRS ness that has consistently earned transfer corporate earnings to sharehold-
typically uses the Bardahl formula as a profit. The board of directors ers while avoiding the income tax on
a starting point for determining if a approved a regular dividend policy dividends (see Regs. Sec. 1.533-1(a)
corporation’s accumulation of earnings based upon X’s available earnings. (2)(i)). In the context of a closely held
may be unreasonable. It is not, however, X’s annual payment of dividends per corporation, a loan or advance of ac-
the only method for a corporation to its dividend policy is a factor tend- cumulated earnings to other commonly
estimate its working capital needs. ing to demonstrate there was not a owned businesses of the shareholder(s)
Adjustments to this calculation or other purpose to avoid shareholder-level could also be viewed as evidence that
methods may be appropriate. income tax. the corporation is attempting to avoid
Next, a corporation should determine payment of dividends to its shareholders
how it will use any earnings accumulated Holding significant investments (see, e.g., Cummins Diesel Sales of Oregon,
in excess of its working capital needs. unrelated to the business 207 F. Supp. 746 (D. Or. 1962), aff’d
Common (but not exclusive) additional Investing accumulated earnings in 321 F.2d 503 (9th Cir. 1963) (interest-
reasons for a corporation to accumulate bonds, equities, or other investments free loans to other corporations owned
its earnings include: (1) acquiring or unrelated to the business could be by shareholder constituted avoidance of
replacing plant, property, and equipment; considered evidence that a corporation shareholder-level income tax)).
(2) expanding operations or making has chosen to earn passive returns on its
strategic acquisitions; (3) adding to earnings instead of paying dividends to Document accumulated
business hazard reserves; (4) adding to shareholders. Nevertheless, companies earnings’ use
product liability loss reserves; and (5) commonly hold investments for legiti- The accumulated earnings tax can be a
paying taxes. mate business reasons unrelated to the hidden penalty tax on highly profitable
avoidance of shareholder-level income corporations that allow their earnings
Example 1: X has been a profitable tax. For that reason, a corporation should to accumulate without paying adequate
business for several years. At the end document how its reasons for holding (or any) dividends to their shareholders.

8 April 2022 The Tax Adviser