Opinion ID: 374307
Heading Depth: 1
Heading Rank: 2

Heading: Atlas' Liability for Accumulated Earnings Tax

Text: 32 Sections 531 and 532 of the Internal Revenue Code impose a tax on accumulated earnings of a corporation formed or availed of for the purpose of avoiding the income tax with respect to its shareholders, by permitting earnings and profits to accumulate instead of being distributed as dividends. 16 Section 533 of the Code provides that accumulation of earnings and profits that are permitted to accumulate beyond the reasonable needs of the corporation's business shall be determinative of a purpose to avoid shareholder income tax, unless the corporation by a preponderance of the evidence proves to the contrary. The reasonable needs of a business include reasonably anticipated needs. 17 An accumulation of earnings and profits is in excess of reasonable needs if it exceeds the amount that a prudent businessman would consider appropriate for the present and future business needs. 18 To justify an accumulation for future business needs, there must be an indication that the corporation has specific, definite, and feasible plans for use of such accumulation. 19 33 The Commissioner determined that Atlas was liable for accumulated earnings taxes for its 1969 and 1970 fiscal years. In those years, Atlas produced earnings and profits considerably in excess of the amounts distributed as dividends to Schaffan. It had experienced substantial profits in prior years as well. Since it was not, in the years in question, engaged in manufacturing, a large portion of its assets was in liquid form. Atlas' net liquid assets the excess of its current assets over current liabilities was $2,195,840.13 at the end of 1969 and $2,470,804.76 at the end of 1970. Its annual operating expenses for those years were $4,788,907.43 and $4,781,537.24, respectively. Before the Tax Court, Atlas advanced two reasons for accumulating earnings and profits; ordinary and extraordinary working capital needs, and accumulation for future expansion of plant facilities. 34 In considering Atlas' working capital requirements, the Tax Court applied the so-called operating cycle test. That test permits accumulation of current earnings to cover the reasonably anticipated costs of operating a business for a single operating cycle. Such a cycle is the length of time the money is tied up in inventory and accounts receivable, and thus unavailable for dividend distribution. 20 The length of the cycle is determined by the average inventory turnover period plus the average accounts receivable turnover period, less the average accounts payable turnover period. The Tax Court determined that Atlas' inventory turnover period was 1.33 months and the accounts receivable turnover period was 2 months, for a total sum of 3.33 months. The court made no deduction for an accounts receivable turnover period because it found that at least half of the inventory, purchased from foreign suppliers, was paid for by letter of credit in effect prepaid. Thus, it concluded that the operating cycle was 3.33 months, or 27.75 percent of the year. To determine Atlas' working capital needs, the court applied that percentage to the total annual operating expenses for the years in question, thus finding working capital needs for 1969 of $1,328,921.72. Because the working capital needs in 1970 differed only slightly, the court allowed the same amount, $1,328,921.72, for that year. As noted above, Atlas had net liquid assets in each year far in excess of that amount. The court found at the beginning of fiscal 1969, accumulated earnings and profits of $1,812,733.70, and at the beginning of fiscal 1970, accumulated earnings and profits of $2,181,196.70. Considering its net liquid assets these accumulations could not be justified as needed for working capital needs. 35 Nor did the Tax Court accept Atlas' explanation that all the accumulations were justified by the need for future plant expansions. The Atlas plant had undergone a major expansion in 1968. While its successful history might require future plant expansion, it had in 1969 no specific, definite, and feasible plan for such expansion. The court concluded that in 1969, Atlas could not justify accumulation of earnings and profits beyond its normal working capital needs. For the fiscal year 1970, however, the Tax Court credited testimony that Atlas had begun to plan for a future expansion and reasonably could need to accumulate $339,000 in that year. It added that sum to the $1,328,921.72 for the fiscal year 1970. But even this total of $1,667,921.72 was exceeded by the $1,812,733.70 in accumulated earnings and profits with which the year opened. 36 Atlas argues that the preponderance of evidence is that its accumulations did not go beyond its reasonably anticipated needs. The findings of the Tax Court, however, must be affirmed unless clearly erroneous. 21 We do not find them so. And to the extent that Atlas urges that the application of the operating cycle test for determining working capital needs was legal error, we reject that contention. The test affords a reasonable formula for making the factual determination required by section 533. 37 Once it was determined that Atlas had accumulated earnings beyond the reasonable needs of the business, the burden was upon Atlas to show that it had not been availed of for the purpose of avoiding shareholder income tax. Noting that Atlas' dividends were small compared to its earnings, that Schaffan's salary was not substantial, and that his marginal tax rate was higher than the corporation's, the Tax Court held that this burden had not been carried. Here, again, the Tax Court's findings of fact are not clearly erroneous. 38