CD ROM Paradise Collection 4/CD ROM Paradise Collection 4 1995 Nov.iso/business/sba952.zip/F310.SBE

Text File | 1995-03-15 | 15KB | 412 lines

@Q01

             ┌──────────────────────────────────────────┐
             │ IS MY COMPANY POTENTIALLY SUBJECT TO THE │
             │   PERSONAL HOLDING COMPANY PENALTY TAX?  │
             └──────────────────────────────────────────┘
Many years ago, the tax laws were amended to keep wealthy in-
dividuals from "incorporating their pocketbooks," e.g., put-
ting their stocks, bonds, and other investments into corpora-
tions, in order to take advantage of the much lower corporate
tax rates that obtained at the time.  Now, nearly six decades
later, corporate tax rates are generally higher than the
rates individuals pay.

But old tax laws never die, once they are on the books.  As a
result, the tax law still imposes a "personal holding compa-
ny" (or "PHC") penalty tax at a rate of 39.6% on the "undis-
tributed PHC income" of companies that are determined to be
personal holding companies.

  QUESTION:  Is your business incorporated (or will it be) ?
@YN
01\Q03
02\Q02

@Q02

CONCLUSION:  Then you do not have to be concerned about the
personal holding company tax problem.  It only applies to
corporations.

@STOP

@Q03


  QUESTION:  Is your corporation an S corporation?

@YN
01\Q04
02\Q05

@Q04

CONCLUSION:  Then your corporation is not subject to the per-
sonal holding company provisions, which apply only to "C
corporations," and not to "S corporations."

@STOP

@Q05

OTHER EXEMPT CORPORATIONS.  Certain other special kinds of
corporations are exempted from the personal holding company
tax.  These include the following kinds of corporations:

       . banks;

       . life insurance companies and surety companies;

       . certain lending or finance companies that meet
         special tests;

       . foreign personal holding companies (these come
         with their own distinct set of tax problems);

       . tax-exempt organizations, and various other
         special kinds of corporations.

 QUESTION: Does your corporation fall within any of the above
           exemptions (or any others that you know apply)?
@YN
01\Q06
02\Q07

@Q06

CONCLUSION: Then, as such an entity, your corporation does
not need to be concerned with the personal holding company
tax, due to its special status.

@STOP

@Q07

STOCK OWNERSHIP REQUIREMENT.  Your corporation will not be
treated as a personal holding company unless its stock is
controlled by a very small number of people, directly or in-
directly.  The rules for determining when stock in a company
is "indirectly" owned by someone are extremely complex and
difficult to work with, so you may need to consult a tax pro-
fessional if you aren't sure whether the corporation is over
50% owned, directly or indirectly, by 5 or fewer people.

Otherwise, just assume that, for example, any stock in the
corporation in question that you own, or that is owned by
your family, or by corporations, trusts, or partnerships in
which you have an interest, will probably be "attributed" to
you, and the same goes for any other person who may have in-
direct ownership of some of the stock.

  QUESTION:  Do 5 or fewer individuals own, directly or
             indirectly, more than 50% of the total out-
             standing stock of the company in question?
@YN
01\Q09
02\Q08

@Q08

CONCLUSION: Then the corporation is not a "personal holding
company," since its stock is too widely held. Thus, so long
as no 5 or fewer individuals own over 50% of the stock (in-
cluding indirect ownership that is "attributed" to them),
the company will not be subject to the personal holding
company tax.

CAUTION:  As noted above, the PHC stock ownership and stock
attribution rules are VERY complex and tricky.  Thus, be-
fore you blithely assume that you escape the PHC rules on
account of the stock ownership test, you may wish to con-
sult your tax adviser.

Of course, just because 5 or fewer people own, or are con-
sidered to own, over 50% of a corporation does not mean
that the corporation is a PHC, if it does not have signi-
ficant "personal holding company income."  Thus, you may
want to go through this Question & Answer session again,
and next time answer "YES" to the stock ownership question,
just to see if you would escape the PHC definition based
on the type of income your corporation generates.

@STOP

@Q09

PERSONAL HOLDING COMPANY INCOME:  If your C corporation de-
rives 60% or more of its "adjusted ordinary gross income"
("AOGI") from certain types of income, such as rents, annui-
ties, interest or dividends, it may be subject to the feder-
al "personal holding company tax."  Other kinds of PHC in-
come to be considered in this 60% test are:

   . most kinds of royalties, plus "produced film rents"

   . amounts received for use of corporate property (tangi-
     ble property) by a 25% or greater shareholder of the
     corporation; and

   . income received from certain personal service contracts
     (such as an athlete or entertainer, for example), where
     the designated performer owns 25% or more of the stock.

  QUESTION: Is personal holding company income 60% or more
            of "adjusted ordinary gross income" ("AOGI") ?
@YN
01\Q11
02\Q10

@Q10

CONCLUSION: Then it would appear that your corporation does
not currently have a personal holding company tax problem,
since its items of "personal holding company income," as
listed above, amount to less than 60% of "adjusted ordinary
gross income."  Looked at another way, your company is free
of personal holding company tax problems if over 40% of its
ordinary gross income each tax year comes from some kind of
active business income, such as sales of merchandise or in-
come from rendering personal services, for example.

@STOP

@Q11

TENTATIVE CONCLUSION:  Then your company may be in danger
of having to pay a 39.6% personal holding company tax on any
after-tax PHC income that it fails to distribute as divid-
ends to shareholders. However, not all is necessarily lost,
if over 50% of its ordinary gross income ("OGI") or adjusted
ordinary gross income ("AOGI"), depending on the category,
comes from any ONE of the following specific categories:
   . rents--if over 50% of AOGI is from "adjusted income
     from rents";
   . mineral/oil/gas royalties--if, as adjusted, they are
     over 50% of AOGI;
   . copyright royalties (other than from works by share-
     holders)--if such qualifying royalties constitute
     over 50% of OGI;
   . active business computer software royalties--if they
     constitute over 50% of OGI;
   . "produced film rents"--if over 50% of the company's OGI.
        QUESTION:  Does your firm qualify under one or
                   more of the above 50% tests?
@YN
01\Q13
02\Q12

@Q12

FURTHER CONCLUSION:  Then it seems, from the answers you
have given, that your corporation may very well have a per-
sonal holding company tax problem.

If so, this means that you have two practical choices, if
you cannot find some way to escape PHC status:

  (1) Pay the 39.6% penalty tax on any personal holding com-
      pany income that is not distributed to shareholders.
      Note that in computing the amount of undistributed
      personal holding company income, for purposes of
      the tax, you start with TAXABLE INCOME of the cor-
      poration, reduced by federal income taxes accrued
      for the year, and make several other adjustments,
      two of the major ones being:

        . The corporation is not allowed a net operating
          loss deduction (except for a loss incurred in
          the preceding year); and

        . It is not allowed the 70% or 80% dividends-
          received deduction for dividend income from
          stock investments.

  (2) Pay out all of the personal holding company income
      (as adjusted, per the preceding paragraph) as divi-
      dends to shareholders.  This will avoid the personal
      holding company tax, but will still result in double
      taxation, of course, since you would be paying out
      all of the after-tax income of the corporation, es-
      sentially, and the shareholders would pay individual
      income tax on the dividends they received -- Not ex-
      actly a wonderful result either!

PLANNING SUGGESTIONS:

  . Try to zero out net income of the corporation by paying
    the largest salaries you feel that you can justify, to
    shareholder-employees. In many PHC situations, however,
    where most of the income is from passive investments,
    you may be likely to run into "reasonable compensation"
    problems with this approach, where the IRS takes the po-
    sition that salaries are excessive, and therefore are
    really dividends in disguise.  In that case, the IRS
    will disallow the excess or "unreasonable" compensation
    as a deduction to the corporation, so that you're right
    back in the soup.

  . Have the corporation elect S corporation status, if it
    is eligible to make such election.  S corporations are
    not subject to the personal holding company tax.  How-
    ever, even if S corporation status can be elected, a
    company that had PHC problems is very likely to have
    lots of "passive income" that may be subject to the
    special S corporation tax, all at the highest corporate
    tax rate -- 35% -- (where "passive investment income"
    exceeds 25% of gross receipts).  If so, it will only
    be allowed to continue as an S corporation for three
    years before it is disqualified.  Also, there can be
    other drawbacks in electing S corporation status, which
    you would need to consider, such as triggering certain
    "built-in gains," LIFO recapture (from having used the
    LIFO method of inventory accounting), and other poten-
    tial tax traps for the unwary and the poorly advised.

  . A more aggressive approach would be to have the corpora-
    tion go into some kind of active business, where it gen-
    erates gross revenues that exceed 40% of its ordinary
    gross income.  Such a new business does not even need
    to show a net profit:  If it generates GROSS revenues
    that are more than 40% of "adjusted ordinary gross in-
    come," your personal holding company tax problem is
    solved.  (This could backfire on you of course, if
    the new business LOSES a ton of money--Saving on taxes
    isn't the only thing to consider!)

@STOP

@Q13

FURTHER CONCLUSION:  Then you MAY be exempt from the person-
al holding company tax, if your firm also meets a number of
other complex definitional requirements (each different)
that apply to each of the 5 categories of special types of
PHC income.  For example, for some of the categories, the
business must have certain types of business expenses that
exceed 15% (for mineral, oil & gas royalties) or 25% (for
active business computer software royalties) of OGI or AOGI.

Also, for several of the categories, other types of PHC in-
come must not exceed 10% of the ordinary gross income (OGI).
Numerous other complex requirements apply, so it is strongly
recommended that you DO NOT, based on this information, con-
clude that you don't have a PHC tax problem just because you
think you qualify under one of the 50% exceptions.  You will
definitely need to consult a competent tax professional for
expert help in determining if your corporation meets one of
the 50% tests and all the related requirements for avoiding
treatment of your major category of income as personal hol-
ding company income.

The only conclusion you should draw on your own at this
point is that you MAY have a shot at avoiding PHC status;
but heed this advice:

  .  SEE YOUR TAX ADVISER ABOUT THIS.

  .  THIS IS NOT THE TIME OR PLACE FOR "DO-IT-YOURSELF"
     BRAIN SURGERY.

  .  YOU ARE IN VERY DEEP WATER HERE!

@STOP

@HELP

@H\01

Answer "YES"  ("Y") to  this  question
even if you are not incorporated,  but
are at least seriously considering the
possibility  of incorporating.   (Then
answer the questions that follow AS IF
your business were incorporated.)

@H\03

An  S corporation is a  regular corpora-
tion that has filed an election with the
IRS (on Form 2553) to be taxed under the
provisions of Subchapter S of the Inter-
nal Revenue Code. That is, it has chosen
to have its income or losses "pass thru"
and be taxable to  (or deducted by)  its
shareholders,  rather than paying income
taxes at the corporate level.

@H\05

Other corporations exempted from the PHC
provisions include:

  . Small Business Investment Companies,
    if no shareholders own a 5% or more
    interest in any small business to
    which the SBIC provides funds.

  . Certain foreign corporations, if all
    their stock is owned, during the
    last half of the taxable year, by
    non-resident aliens and/or foreign
    entities owned by non-resident
    aliens.

@H\07

Note that, even if you only hold an op-
tion to  acquire stock of  the company,
you are  considered  as already  owning
the  stock subject  to the option,  for
purposes of  the PHC attribution rules.
These rules on indirect stock ownership
are very wide-reaching, and hard to get
around.

@H\09
"Adjusted Ordinary Gross Income"  is the
ordinary GROSS income (excluding capital
gains) of a corporation,  before any de-
ductions, except for certain adjustments
applicable to  rental income and mineral
and oil and gas royalty income (such  as
depreciation or depletion, property tax,
interest and rents paid), and other mis-
cellaneous  adjustments that  apply only
to  certain  kinds of  special taxpayers
and types of income.   Rather technical!

(You may want to just look at  gross in-
come, less capital gains, to get a rough
idea of whether you have a PHC problem.)
@H\10

PLANNING TIP:  If your company has a PHC
tax  problem,  or is  close to the line,
under the 60% test, one way to solve the
PHC problem would be for the corporation
to enter some kind of active business as
a sideline. Such a new business does not
even need  to show a  net profit:  If it
generates  GROSS revenues  that are more
than 40% of the  corporation's  adjusted
ordinary gross income, the personal hol-
ding company tax problem is solved.

@H\11

NOTE:  Each of these five categories has
its own set of special,  different,  and
very complex requirements, which are far
too detailed  to go into here.  However,
if your business  clearly generates most
of its revenues from one of the 5 listed
categories, enter "YES", since you might
have a good chance  of qualifying  under
that particular exception to the person-
al holding company tax provisions.

@END