Monster Media 1996 #14/Monster Media No. 14 (April 1996) (Monster Media, Inc.).ISO/business/sba961.zip/F104.SBE

Text File | 1996-01-01 | 7KB | 144 lines

@080 CHAP 8

       ┌──────────────────────────────────────────────────┐
       │ THE PERSONAL HOLDING COMPANY TAX ON CORPORATIONS │
       └──────────────────────────────────────────────────┘


@IF120xx]       NOTE REGARDING @NAME:
@IF120xx]┌────────────────────────────────────────────────────────────┐
@IF120xx]│Because your business isn't incorporated, the following dis-│
@IF120xx]│cussion of personal holding taxes is not relevant to you un-│
@IF120xx]│less you are considering incorporation.                     │
@IF120xx]└────────────────────────────────────────────────────────────┘
@IF120xx]
@IF118xx]       NOTE REGARDING @NAME:
@IF118xx]┌────────────────────────────────────────────────────────────┐
@IF118xx]│Because your corporation is an "S corporation," you do not  │
@IF118xx]│have to be concerned with the personal holding company pen- │
@IF118xx]│alty taxes discussed below, which apply only to "C" corpora-│
@IF118xx]│tions, unless you are considering a change to "C" status.   │
@IF118xx]└────────────────────────────────────────────────────────────┘
@IF118xx]
The Personal Holding Company tax is a federal penalty tax
on a corporation 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.  Since
the Tax Reform Act of 1986 went into effect, and until re-
cently, corporate tax rates have been 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.  (But, in any case, the 1993 Deficit Reduction
legislation has increased the maximum corporate rate only
to 35%, while increasing the top individual rate to 39.6%,
so that individual rates are, once again, higher than
corporate.)

The Personal Holding Company Tax, when imposed, is a flat
39.6% tax on the "undistributed personal holding company
income" of the corporation.

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 tak-
ing advantage of a tax "loophole" by incorporating their
stock portfolios or savings accounts.

If a closely-held corporation gets a large proportion of
its gross income, usually 60% or more, in the form of
"personal holding company income" such as dividends, in-
terest, rents, and royalties, it will generally be consid-
ered 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 perform 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 in-
come.  This would put a damper on such schemes as having
your corporation buy a yacht and charter it to you, for
example.

A corporation will only be considered a personal holding
company if 5 or fewer people (including any stock that
is "deemed" to be owned by them, through certain "tax
relatives" or related businesses or trusts) are considered
as owning more than 50%  of the stock of the corporation in
question.

@IF110xx]-------------------------------------------------------------
@IF110xx]NOTE:  Because over 50% of the stock of your firm, a closely-
@IF110xx]held C corporation, is held by 5 or fewer stockholders, there
@IF110xx]is a distinct possibility (if it has substantial PHC income)
@IF110xx]that your company could be subject to the personal holding
@IF110xx]company penalty tax.  Consult your tax adviser IMMEDIATELY if
@IF110xx]you are not already sure about the personal holding company
@IF110xx]tax status of @NAME.
@IF110xx]-------------------------------------------------------------
@IF110xx]
@IF112xx]-------------------------------------------------------------
@IF112xx]NOTE:  Because your firm does not have 5 or fewer individuals
@IF112xx]who own over 50% of its stock, it appears the PHC penalty tax
@IF112xx]is not a problem for @NAME.
@IF112xx]-------------------------------------------------------------
@IF112xx]
If a corporation comes within the definition of a personal
holding company, the tax law imposes a 39.6% 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 cor-
porate 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 additional 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 re-
sult, 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 concerned about being treated as PHC's, since they
will seldom get 60% or more of their gross income from
passive sources like dividends and interest.  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 ser-
vices.  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 com-
pany income."

Another type of operating company that frequently encoun-
ters 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 soft-
ware firms will not be able to qualify for this relief
without very careful planning.