AET Guide 2025

The Accumulated Earnings Tax (AET)

A strategic guide to navigating IRC § 531 compliance, audit risks, and defense strategies in the modern 2025 corporate tax environment.

Executive Summary

The Accumulated Earnings Tax (AET) is a 20% penalty tax imposed on C corporations that retain earnings beyond the "reasonable needs of the business" to avoid shareholder-level taxes.

In 2025, this tax has gained renewed vitality due to static statutory thresholds, the "One Big Beautiful Bill Act" (OBBBA), and sophisticated IRS enforcement. The cost of failure is high: a 20% penalty on top of the 21% corporate rate, effectively creating a 41% tax burden.

The Penalty

20% flat tax on "accumulated taxable income," assessed in addition to regular corporate income tax.

The Trigger

Accumulating earnings beyond $250,000 without specific, definite, and feasible business plans.

The Defense

Active documentation of business needs and quantitative analysis using the Bardahl formula.

The Basics (IRC § 531-537)

The Core Concept

The IRS wants to prevent you from using a C Corp as a personal savings account. If you don't pay dividends, they want a valid business reason why.

Who is at Risk? (IRC § 532)

  • Closely Held C Corps: The primary target. Public companies are rarely targeted, but private companies with high cash balances are vulnerable.
  • Exceptions: S Corps, Personal Holding Companies (PHCs), and Tax-Exempt orgs are generally exempt from AET (they have their own rules).

The Statutory Credit (Safe Harbor)

Every corporation gets a lifetime "free pass" credit amount. Accumulations below this are generally safe.

$250,000
Standard Minimum Credit
Has not been indexed for inflation since 1981.
$150,000
For Service Corporations (PSCs)
Law, Health, Engineering, Architecture, Accounting, Actuarial, Consulting.

Why Now? (2025 Risks)

The environment for 2024-2025 has created a perfect storm for AET audits.

Rate Arbitrage

Strategy: Retain earnings at 21% Corp Rate vs. paying 37% Individual Rate + 3.8% NIIT.

Risk: The IRS knows this math perfectly. The 20% AET is designed specifically to close this gap (21% + 20% ≈ 41%).

Inflation vs. Static Credit

The $250,000 credit was set in 1981. Adjusted for inflation, it should be over $850,000.

Result: "Bracket creep" pushes small businesses out of the safe harbor much faster today, exposing them to audits earlier in their lifecycle.

New Legislation (OBBBA)

The One Big Beautiful Bill Act (July 2025) reinstated R&E expensing.

Impact: Lower taxable income initially, but potential divergence between "book" and "tax" income can flag audits if Schedule M-3 discrepancies are high.

Moore v. United States

Supreme Court (2024) affirmed Congress's power to tax undistributed income.

Impact: The constitutional foundation of AET is secure, emboldening the IRS to enforce it aggressively without fear of legal challenges.

Qualitative Defense: "Reasonable Needs"

Once you exceed the $250k credit, you must prove your accumulations are for "reasonable needs." The standard is "Specific, Definite, and Feasible."
✅ Valid Grounds for Accumulation
  • Bona Fide Expansion: Purchasing new machinery, building facilities (requires blueprints/contracts).
  • Acquisition: Buying stock or assets of a competitor or supplier (active business only).
  • Debt Retirement: Sinking funds for bona fide long-term debt.
  • Working Capital: Cash needed for one operating cycle (see Bardahl Formula).
  • Product Liability Loss Reserves: Specific reserves for anticipated claims.
❌ Invalid Purposes ("Badges of Fraud")
  • Loans to Shareholders: The "deadly sin" of AET. Implies you have excess cash to lend to owners.
  • Unrelated Investments: A manufacturer holding a large portfolio of tech stocks or crypto.
  • Vague Hazards: Accumulating for "general depression" or "market risks" without quantification.
  • Benefit of Individual: Any accumulation primarily to lower the individual tax bracket of shareholders.
⚠️ The Trap of Contingencies (Alta Peruvian Lodge Case)

The Mistake: Alta Peruvian Lodge accumulated $2.5M for "renovations and bad snow years" but lacked architectural contracts or specific minutes.

The Lesson: General risks are not enough. You must quantify the risk (e.g., "Actuarial analysis shows a bad season costs $1.2M") and formally set aside a reserve.

Quantitative Defense: Bardahl Formula

The courts use the Bardahl Formula to calculate exactly how much working capital you are allowed to retain tax-free. It calculates the cash needed to cover one "operating cycle."

Peak vs. Average Method

The IRS prefers using Average balances (lower deduction). You should almost always calculate and defend using Peak balances (highest month of the year) to maximize your defensible retention.

Bardahl Formula Estimator

Financial Inputs (Annual)

Average Balance

Operating Cycle Length
0.0 Days
(Inv: 0 + AR: 0 - AP: 0)
Defensible Working Capital
$0
0.00% of Annual Operating Costs

Strategic Defense Checklist

2025 Action Plan

Run the Bardahl Calculation

Perform both Average and Peak cycle calculations. Keep the Peak one in your permanent file.

Clean Up Shareholder Loans

Eliminate them immediately. If unavoidable, ensure they are secured with market interest rates.

Update Corporate Minutes

Board minutes must be specific. "We plan to expand" is bad. "We authorized $3M for Project X, zoning pending" is good.

Review Liquidity

Does your balance sheet match your story? If you are saving for a factory, funds should be in Treasuries, not volatile equities.

Consider the "Top-Up" Dividend

Under IRC § 563, dividends paid by March 15th (2.5 months after year-end) count for the prior year. Use this to clear excess AET liability.