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Corporate Tax Laws and Improper Accumulation of Income

written by: John Garger•edited by: Michele McDonough•updated: 9/3/2010

Current tax laws do not allow a corporation to accumulate large sums of retained earnings in lieu of distributing dividends. Doing so incurs a tax penalty.

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    Tax Penalties on Retained Earnings

    A dividend is a share of corporate earnings distributed to shareholders on a regular basis. Shareholders typically report this income on personal income tax. However, a corporation that holds on to retained earnings in lieu of paying a dividend may face an additional tax liability.

    United States tax laws do not allow a company to retain its earnings when doing so is for the purpose of allowing shareholders to realize gains in the value of stock without having to pay taxes on distributed dividends. Certainly, corporations are allowed to retain earnings for the running of normal business operations but this amount must not exceed $250,000.

    Sums of retained earning exceeding $250,000 are subject to a penalty tax if it is found that retained earnings were not necessary for the operational needs of the firm. Reasonable operations include buying assets, paying off debts, reinvesting in plant and equipment, etc.. Although the penalty is not often imposed, the threat of such a penalty is real and affects the financial decisions made by a firm’s managers.

    The significance of the tax penalty is a matter of financial self-interest for stockholders. It may be that the payment of dividends dilutes an investor’s financial position both because the value of shares of stock is reduced after a dividend payout and because dividends are taxable income on the investor’s personal income tax.

    When considering financial position, the wise investor is always aware that value is more important than wealth in the short term because an asset can always be sold. Receiving dividends may be appealing because it represents an actual cash flow in the investor’s direction. However, payment of dividends that dilute stock value may put the investor in a worse position than if dividends were not paid. An investor must weigh the cost of holding on to stock just prior to dividend payouts; the investor must always consider the financial position of his/her stock before dilution occurs.