Avoiding Personal Holding Company Tax
A personal holding company (PHC) is a type of C corporation characterized by more than 50% of the value of its outstanding stock being owned directly or indirectly by five or fewer individuals. Additionally, at least 60% of its adjusted ordinary gross income must come from passive sources. The purpose of the PHC tax is to prevent closely held corporations from using the lower corporate tax rates to shelter passive income and avoid higher individual tax rates. The PHC tax is levied on undistributed income of C corporations that predominantly generate income from passive investments, such as dividends, interest, royalties, rents, annuities, and other similar sources. The underlying idea is that a corporation should primarily engage in active business operations rather than serving as a vehicle to shield passive income from higher individual tax rates. Avoiding PHC status is crucial because failing to do so may lead to additional taxation. A PHC is subject to a corporate tax rate of 20% on its undistributed income. From 2003 to 2012, the tax rate was 15%, but it increased to 20% in 2013 with the enactment of the American Taxpayer Relief Act of 2012. To qualify as a personal holding company, the corporation must meet two criteria:
1. At least 60% of its adjusted ordinary gross income should consist of PHC income.
2. At any time during the last half of the tax year, more than 50% of the corporation's outstanding stock must be owned (directly or indirectly) by (or for) five or fewer individuals. PHC income includes various sources of primarily passive income, such as dividends, certain interest amounts, royalties (after certain expenses), annuities, specific rental income, and compensation for corporate property usage by shareholders who own at least 25% of the corporation's stock. Adjusted ordinary gross income for a PHC is the corporation's gross income minus gains from the sale of capital assets, certain foreign income, certain expenses allowed against rental and royalty income, and certain interest income. However, there are exceptions to the definition of a personal holding company. Some businesses that meet the income and ownership tests are excluded from PHC classification and taxation. These exceptions include tax-exempt corporations, banks, domestic building and loan associations, life insurance companies, certain lending or finance companies, certain foreign companies, certain small business investment companies operating under the Small Business Investment Act of 1958, and corporations under the jurisdiction of the court in a Title 11 or similar bankruptcy case. To avoid PHC taxation, corporations should closely monitor their accumulated earnings and the types of income they receive throughout the year. Some strategies to avoid PHC status include:
1. Increasing the number of business owners to ensure that the top five owners own less than 50% of the value of outstanding stock.
2. Adjusting the relationship between operating income and passive investment income, such as accelerating sales and billing at year-end, decreasing expenses, investing in other business activities, cashing in some securities and reinvesting in growth stocks, and paying dividends to stockholders.
3. Limiting passive investments and shifting the composition of income to reduce PHC income. While converting from a C corporation to an S corporation might seem like a solution, it may not always be effective. S corporations with prior C corporation earnings and profits (E&P) and more than 25% of gross receipts from PHC income sources could still be exposed to a corporate-level tax of 35% on excess net passive income.
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