Section of Taxation Publications
  VOL. 59
NO. 2
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Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.


Kamran Idrees

Associate, International Tax Group, Deloitte Tax LLP, Chicago, Illinois; Boston University, B.A., 1996; Loyola University Chicago School of Law, J.D. 2003; LL.M. 2005. The author wishes to thank Professor Jeffrey L. Kwall, for his guidance and insightful commentary. This paper was adopted from a paper prepared for the L.L.M. Tax Seminar at Loyola University Chicago School of Law.


Generally, the Internal Revenue Code treats corporations as independent taxpaying entities, regardless of the personal characteristics of their shareholders. Thus, corporate income is first taxed to the corporation as it is earned, and then it is taxed again at the shareholder level when corporate earnings are distributed in the form of dividends. This treatment of corporate income forms the basis for the United States’ system of double taxation. Taxpayers have often sought to avoid this double taxation by forgoing the payment of dividends to shareholders and instead allowing corporate income to accumulate within the corporate entity. This strategy defers the second level of taxation until corporate earnings are ultimately distributed to shareholders. Congress, however, has armed the Service with certain statutory weapons to deal with taxpayer attempts to insulate corporate income from shareholder-level taxation. One of these weapons is the accumulated earnings tax. The accumulated earnings tax, a rare but strict 15% penalty tax, is imposed on any current year undistributed earnings and profits that a corporation has unreasonably accumulated. The purpose of the accumulated earnings tax is to prevent shareholders from avoiding income tax on dividends by allowing earnings and profits to accumulate within the corporate entity beyond the reasonable needs of the business instead of receiving taxable dividends. The tax imposed by sections 531-535 is levied on a corporation’s accumulated taxable income, a figure calculated by making several adjustments to its taxable income. Currently, there is a split between the Ninth and Fifth Circuit Courts of Appeal over the timing of the adjustment allowed for accrued federal income taxes when determining a corporation’s accumulated taxable income. Resolving this controversy over the timing of accrued taxes would greatly affect the calculation of corporate earnings ultimately subject to the penalty tax. In Metro Leasing and Development Corporation v. Commissioner , the Ninth Circuit did not allow a tax deficiency that had already been paid to be deducted in calculating accumulated taxable income, because the taxpayer continued to contest the deficiency. The Ninth Circuit’s ruling not only created a split in the circuits; it suggested that the purpose of the accumulated earnings tax may be in conflict with basic principles of accrual accounting. Specifically, Metro Leasing conflicts with an earlier Fifth Circuit case, J.H. Rutter Rex Manufacturing Company v. Commissioner , in which the court, under a virtually identical set of facts, held that a paid yet still–contested tax liability did indeed accrue for the limited purpose of calculating accumulated taxable income and allowed the taxpayer to deduct the liability. This article reviews both courts’ opinions and demonstrates that the Fifth Circuit reached the correct result. Part II provides a general overview of the accumulated earnings tax, and Part III describes the factual set of circumstances that led to the circuit split over the accrual of contested tax liabilities. After presenting the historical development of the applicable accrual principles, Part IV analyzes the points of disagreement between both circuit courts, while Part V concludes that the rationale employed by the Fifth Circuit properly harmonizes those accrual principles with the overall purpose of the accumulated earnings tax.


Published by
Section of Taxation, American Bar Association
With the Assistance of
Georgetown University Law Center


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