ROBERT E. MCKENZIE, ESQ.

ARNSTEIN & LEHR

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1. I.R.C. §§ 531 through 537 govern the imposition of a surtax on corporations deemed to have engaged in
unreasonable (i.e., excessive) accumulations of earnings and profits for purposes including the insulation of
shareholders against income taxes which they would have had to pay if the corporations had paid out (more
of) their incomes in dividends. Taxpayers against whom the accumulated earnings tax is asserted have-as is
common to liabilities imposed under subtitle A of the Code-two alternative (and mutually exclusive)
remedies: redetermination (prior to any payment) of liability by the Tax Court; or refund suit (following
payment) in either the Claims Court or the appropriate U.S. district court.

2. I.R.C. § 531 imposes the tax. I.R.C. § 532 defines the corporations to which the tax applies. I.R.C. § 533
amplifies I.R.C. § 532 and generally puts the burden of proof concerning the absence of the proscribed
purpose on the corporations if their accumulations exceed their reasonable needs.

3. I.R.C. § 534 is for purposes of both these instructions and Tax Court cases the most significant of the
statutory provisions dealing with the accumulated earnings tax. It allows-in cases before the Tax Court,
only-the taxpayer, in certain circumstances, to shift to the Commissioner the burden of proving accumulation
beyond the reasonable needs of the business.

4. I.R.C. § 535 defines "accumulated taxable income." I.R.C. § 536 is a technical pronouncement not
immediately pertinent here. I.R.C. § 537 provides that "reasonable needs of the business" include "reasonably
anticipated" needs. All such reasonable needs, present or prospective, are necessarily needs for the use of
capital.

5. Capital can be used either on a long term basis, i.e. , buildings, machinery and equipment or, short term, to
provide money for operating expenses during recurrent expenditures--receipt cycles, as for example, a
Christmas tree ornament manufacturing concern which may make its products during the first two quarters of
every year, ship them to customers in the third quarter and receive the bulk of its cash flow in the fourth
quarter.

A. Accumulations of earnings for long term purposes ordinarily qualify as reasonable only if supported by the
prior establishment of a definite and feasible plan for their use for a specific (capital) purpose within a
realistic period.

B. Retentions of earnings for use as operating capital through the course of a disbursement--receipt business
cycle are viewed as held for reasonable business needs only to the extent established by a version or variation
of the "Bardahl Formula."

6. Significantly, the I.R.C. § 531 issue comprises one instance in which a taxpayer obtains a tactical
advantage by choosing the Tax Court as the forum for relief. By complying with the provisions of I.R.C. §
534 the taxpayer may shift to the Commissioner the burden of proving whether earnings and profits have
been allowed to accumulate beyond the reasonable needs of the taxpayer's business. An amount equal to
whatever amount of the current earnings that are retained for the reasonable needs of the business is allowed
under I.R.C. § 535(c) as a part of the accumulated earnings credit in the computation of the accumulated
taxable income subject to the additional tax. In view of the interrelationship of the allowance of such
accumulated earnings credit, a determination as to reasonable business needs is implicit in the computations.
Therefore determination of the reasonable needs of the business is pertinent both as an evidentiary matter
which may be determinative of the proscribed purpose and in the computation of any accumulated earnings
subject to tax.

7. In defending accumulated earnings tax cases, in whatever court, the Government is not under any
requirement or duty to allege or prove the amount of tax "saved" by any stockholder in consequence of the
purported unreasonable accumulation of corporate earnings. However, in any given case, the trial attorney
may adopt that tactic to strengthen the Government's position. A stockholder's return can be used as
evidence. However, even though disclosure of the returns is permissible for that purpose, it is preferable to
limit disclosure as much as possible and proceed through stipulation whenever feasible.

Statutory Procedures in Tax Court Cases Concerning Burden of Proof as to Reasonable Business Needs

1. I.R.C. § 534 provides that the burden of proof in the Tax Court with respect to an allegation that all or any
part of earnings and profits have been permitted to accumulate beyond the reasonable needs of the business
shall: If a notification with respect thereto has not been timely sent, be on the Commissioner; or-If a
statement has been timely submitted by the taxpayer in response to such notification, be on the Commissioner
with respect to those grounds set forth in such statement in accordance with the statutory provisions. Any
determination imposing the accumulated earnings tax is necessarily based on some sort of allegation that
earnings have been accumulated beyond the reasonable needs of the business inasmuch as the
interrelationship of the accumulated earnings credit, including an allowance for current earnings retained for
the reasonable needs of the business, would otherwise eliminate the accumulated taxable income.

2. I.R.C. § 534 has no effect with respect to the burden of proof as to the ultimate test of whether the
corporation was formed or availed of for the prohibited purpose.
3. In order to avoid or to limit the burden of proof with respect to the reasonable needs of the business, the
Service must timely send by registered or certified mail a notification informing the taxpayer that a proposed
assertion of tax or addition to tax includes imposition of the accumulated earnings tax. To be timely, such
notification must be sent prior to the issuance of the 90-day letter.

4. If a timely notification has been sent, the taxpayer must timely submit a valid statement in response thereto
in order to shift to the Commissioner the burden of proof as to the grounds (supported by facts to show the
basis thereof) set forth in such statement to establish that earnings were not accumulated beyond the
reasonable needs of the business. To be timely, taxpayer's statement must be submitted within 60 days (with a
30-day extension available) after the mailing of the notification. To be properly submitted the statement must
be sent to the Internal Revenue Service office which issued the notification of the proposed assertion of the
accumulated earnings tax.

5. If the taxpayer has submitted to the Commissioner a statement purported to satisfy the requirements of
I.R.C. § 534(c), the Tax Court will ordinarily, on timely motion filed after the case has been calendared for
trial, rule prior to the trial on whether such statement is sufficient to shift the burden of proof to the
Commissioner to the limited extent set forth in I.R.C. § 534(a)(2). See T.C. Rule 142(e).