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Text File | 1996-08-23 | 15KB | 414 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
individuals from "incorporating their pocketbooks," e.g.,
putting their stocks, bonds, and other investments into
corporations, 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
company" (or "PHC") penalty tax at a rate of 39.6% on the
"undistributed 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
personal 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
indirectly.  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
professional 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
indirect ownership of some of the stock.

  QUESTION:  Do 5 or fewer individuals own, directly
             or indirectly, more than 50% of the total
             outstanding 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
(including 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,
before you blithely assume that you escape the PHC rules
on account of the stock ownership test, you may wish to
consult your tax adviser.

Of course, just because 5 or fewer people own, or are
considered to own, over 50% of a corporation does not
mean that the corporation is a PHC, if it does not have
significant "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
derives 60% or more of its "adjusted ordinary gross income"
("AOGI") from certain types of income, such as rents,
annuities, interest or dividends, it may be subject to the
federal "personal holding company tax."  Other kinds of PHC
income to be considered in this 60% test are:

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

   . amounts received for use of corporate property
     (tangible 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
income 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 dividends
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
     shareholders)--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
personal 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
      company 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
      corporation, 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
      dividends 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, essentially, and the shareholders
      would pay individual income tax on the dividends
      they received -- Not exactly 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
    position 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.
    However, 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
    potential tax traps for the unwary and the poorly
    advised.

  . A more aggressive approach would be to have the
    corporation go into some kind of active business, where
    it generates 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 income," 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 personal
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
income 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, conclude 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 holding 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 simply a  regular
corporation that has filed an election
with the IRS (on Form 2553) to be taxed
under the provisions of Subchapter S of
the Internal Revenue Code.  That is, it
has chosen to have its income or losses
"pass through" 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
option 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
deductions, except   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
various  adjustments that  apply only to
certain kinds  of special  taxpayers and
types of income.  Rather technical!

(You  may want  to simply look at  gross
income less capital gains,  for  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
holding 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 special  exception  to the personal
holding company tax provisions.

@END