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@080 CHAP 8
┌──────────────────────────────────────────────────┐
│ THE PERSONAL HOLDING COMPANY TAX ON CORPORATIONS │
└──────────────────────────────────────────────────┘
"God must love the rich, or He wouldn't divide
so much among so few of them." -- H.L. Mencken
The Personal Holding Company tax is a federal penalty tax on a corpora-
tion that is used by wealthy owners like an "incorporated pocketbook,"
to take advantage of corporate tax rates, or at least that was the
theory behind the tax when it was enacted back in the 1930s, when
corporate tax rates were much lower than individual tax rates. Now,
since the Tax Reform Act of 1986 went into effect, corporate tax rates
rates are 6% HIGHER (maximum rates) than individual rates, so there
would seem to be little reason to maintain this penalty tax. No matter.
Once Congress enacts a tax law, we are stuck with it forever, usually.
The personal holding company tax is now mainly a trap for the unwary,
or for small corporations that can't afford good enough tax talent to
keep them out of the clutches of this tax, rather than a measure to
stop the rich from taking advantage of a tax "loophole" by incorporat-
ing their stock portfolio or savings accounts.
If a closely-held corporation gets a large proportion of its gross in-
come, usually 60% or more, in the form of "personal holding company
income" such as dividends, interest, rents, and royalties, it will
generally be considered a "personal holding company" (PHC) for tax
purposes. Certain other non-passive kinds of income will also be con-
sidered PHC income, such as income in a service business where anyone
other than the corporation (the customer or client, for instance) has
the right under a contract to designate the individual who is to per-
form the services, where the person designated owns at least 25% of
the stock of the corporation. Also, payments a corporation receives
from a 25% shareholder for use of its property is PHC income. This
would put a damper on such schemes as having your corporation buy a
yacht and charter it to you, for example.
If a corporation comes within the definition of a personal holding
company, the tax law imposes a 28% penalty tax on any PHC income that
is not distributed as a dividend, as a general rule. This tax is
IN ADDITION TO any regular corporate income tax the company pays.
A company faced with the prospect of a PHC tax on its income often
has little choice but to hastily declare a dividend of all of its
net PHC income for the year before the end of its tax year. (An addi-
tional dividend of up to 20% of the dividends paid in the year just
ended can be made within 2 1/2 months after the tax year ends, and
treated as though distributed in the prior year, if the taxpayer so
chooses.) The result of, course, will still be double taxation, since
the shareholders will be paying tax on income that has already been
taxed once at the corporate level, for the most part.
A more effective long-term approach for avoiding PHC tax is to have
the corporation elect S corporation status, where that is possible,
since an S corporation is not subject to the PHC tax. Of course, if
the corporation has ineligible shareholders (such as corporations or
non-resident alien individuals) or over 35 shareholders, for example,
an S corporation election will not be allowed.
Most actively conducted small businesses will not need to be very con-
cerned about being treated as PHC's, since they will seldom get 60% or
more of their gross income from passive sources like dividends and in-
terest. The kind of small business most likely to have a PHC tax
problem is the personal service business, where the corporation enters
into contracts where it agrees to provide the services of an employee
(such as a pro basketball player) who is a sole or major shareholder.
The best way to avoid this problem is to specify in the contract that
the corporation reserves the right to designate the person who will
provide the services. You will need to consult your tax adviser before
entering into any such personal service contract, however, since the
tax rules in this area are quite subtle and the tax penalty is very
heavy if the income under the personal service contract is considered
to be "personal holding company income."
Another type of operating company that frequently encounters PHC tax
problems is the developer of computer software that generates much of
its income from software licensing agreements. While the Tax Reform
Act of 1986 included a special exemption from the PHC provisions for
corporations actively engaged in the computer software business, the
terms of this exception are quite technical and many software firms
will not be able to qualify for this relief without very careful plan-
ning.