In Knight Furniture Co., Inc. v. Commissioner of Internal Revenue, T.C. Memo 2001-19 (January 29, 2001), the Tax Court rejected the IRS’s argument that a company had improperly accumulated earnings and profits rather than paying dividends to shareholders, and therefore should pay an accumulated earnings tax. This case is instructive because potential tax liabilities can have an impact on the value of a business.

Knight Furniture Company had retained earnings and profits in excess of $6 million in each of three consecutive years.  The company had a history of limited debt, high liquidity, and conservative management.  In analyzing the needs of the company, the court said the critical factor was "not the monetary size of the accumulated earnings and profits, but rather the corporation’s liquid position and the relation of that position to the corporation’s current and anticipated needs."

Knight argued that it had several justifications for retaining earnings, including a class action lawsuit against the company, business expansion plans, redemption of stock of dissenting stockholders, liquidity needs, investments in unrelated businesses, dividend history, and repairs and renovations.

The court proceeded with the understanding that the available liquid assets consisted of current assets minus current liabilities for each year in question.  Next, the court determined whether the reasons offered by Knight for accumulating earnings were justified by reasonably anticipated needs.  In several areas, the court determined the IRS had met its burden of proof. For example, the court concluded that the company had no specific business expansion plans, and it also found that the class action lawsuit had been dismissed and that the needs of the company in that regard should be restricted to $100,000 of potential legal fees.  In most areas, though, the court found that the IRS had not met its burden. For example, the court adopted the company’s position that shareholder dissent required maintenance of liquid assets.

After completing the analysis, the court held that the company’s reasonably anticipated needs substantially exceeded liquid net assets. The company was therefore not liable for accumulated earnings taxes.