Tax problems and administrative difficulties can arise if a corporation is classified as a personal holding company (PHC). Avoiding PHC status is important because:
- The income will be taxed at the regular corporate rate when it is earned by the corporation.
- If the income is not distributed and the corporation is subject to the PHC tax, a 20% tax will be imposed on the undistributed personal holding company income (Sec. 541).
- When the income is finally distributed to the shareholder (e.g., as a dividend), it will be taxed at the shareholder level. Even if it is distributed to the shareholder in the form of a deductible expense (e.g., compensation) after the PHC tax has been paid, it will be subject to double-taxation, i.e., the corporation paid the PHC tax on the income, and the shareholder pays tax on it when it is received.
The purpose of the PHC tax is to prevent corporations from accumulating their earnings instead of distributing those earnings as taxable dividends. Qualified corporate dividends are taxed to noncorporate shareholders at a maximum rate of 20%. These dividends, if not qualified, otherwise would be taxed at a 39.6% rate (for 2016, gain recognized by single filers with taxable income above $415,050, married couples filing jointly with taxable income above $466,950, heads of household with taxable income above $441,000, and married taxpayers filing separate returns with taxable income above $233,475). A 15% tax rate applies to qualified dividends that otherwise would be taxed at a 25%, 28%, 33%, or 35% rate; and a 0% tax rate applies to qualified dividends that otherwise would be taxed at a 10% or 15% rate.
Although the maximum tax rate on qualified dividends is 20% (Secs. 531 and 541), it could be worse because the accumulated earnings tax (AET) and PHC tax rates do not reflect the 3.8% net investment income tax imposed on higher-income individuals. This can result in a maximum 23.8% tax rate on qualified dividends. On the other hand, dividends paid to shareholders may be taxed at a lower 15% or 0% rate.Adjusting AMT for Circulation Expenses
The alternative minimum tax (AMT) adjustment for circulation expenses does not apply to any corporations other than PHCs. For purposes of the AMT, a PHC must capitalize circulation expenses that are fully deductible for regular tax purposes (Sec. 56(b)(2)(C)). The amount capitalized is amortized ratably over three years.Exposing the Corporation to At-Risk and Passive Activity Loss Rules
Shareholders are in control of a corporation for purposes of the at-risk and the passive activity loss (PAL) rules if, at any time in the last half of the tax year, a group of no more than five individuals owns (directly or indirectly) more than 50% in value of the corporation's stock (Secs. 469(j)(1) and 465(a)(1)(B), referring to Sec. 542(a)(2)). This is the same ownership requirement that applies for determining whether a corporation is a PHC.
A corporation is subject to the at-risk rules and the PAL rules not because it is a PHC, but because it meets the PHC stock ownership test. Thus, a corporation that meets the PHC stock ownership test but does not meet the PHC income test is still subject to the at-risk and PAL rules.Making an S Election
The PHC rules do not apply to S corporations. However, a C corporation that makes the S election is still subject to the PHC rules for the years in which it was a C corporation. If the S corporation election is to be effective retroactively to the first day of the tax year, it must be made by the 15th day of the third month following the beginning of the year. While S corporations are not subject to the PHC tax, S corporations are subject to a corporate-level tax on excess passive income, which is based on the same type of income as the PHC tax, if the S corporation has C corporation earnings and profits from before conversion (Sec. 1375(a)).Benefiting From PHC Status
A PHC is not subject to the AET (Sec. 532(b)(1)).Avoiding PHC Status
PHCs do not include the corporations listed in Sec. 542(c). When a corporation changes its status from a PHC to a corporation exempt from the PHC tax, or vice versa, it is subject to the PHC tax only during the part of its tax year when it was not exempt from the tax. Thus, when a calendar-year corporation is a PHC for the first nine months of the year but qualifies as a bank during the last three months, it is subject to the PHC tax only for the period Jan. 1—Sept. 30 (Rev. Rul. 63-103).Applying the Two Tests for PHC Status
The determination of PHC status is based on two objective tests. The intent or motive of the corporation or shareholders is irrelevant. The penalty tax applies when the objective tests are met even if no accompanying tax-related motives exist. If a corporation meets both tests, it is a PHC (unless it is an excluded corporation as previously described).
Income test: At least 60% of the corporation's adjusted ordinary gross income is PHC income (Sec. 542(a)(1)).
Stock ownership test: More than 50% of the value of the corporation's outstanding stock is owned (directly or indirectly) by five or fewer individuals on any day during the last half of the corporation's tax year (Sec. 542(a)(2)). Few closely held corporations have sufficiently diverse ownership to avoid PHC status based on this test.
Practice tip: Most closely held corporations will find it easier to fail the income test than the stock ownership test. (Both tests must be met for a corporation to be classified as a PHC.) Therefore, when determining if a corporation is a PHC, it generally saves time to perform the income test first. Only if the corporation meets the income test will the stock ownership test need to be performed.
This case study has been adapted from PPC's Tax Planning Guide—Closely Held Corporations, 29th Edition, by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2016 (800-431-9025; tax.thomsonreuters.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.