Software of the Month Club 1997 March

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@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