Beware the personal holding company tax

Editor: Valrie Chambers, CPA, Ph.D.

Congress reduced the highest rate of income tax on corporations from 35% to 21% in the law known as the Tax Cuts and Jobs Act, P.L. 115-97. At the same time, the highest rate of income tax on individuals was lowered to 37% — which is still much higher than the reduced corporate rate. The sharp reduction in the corporate rate, particularly as compared with the individual rate, has potentially made the corporate form more attractive, at least from a marginal tax rate perspective, versus other flowthrough entity forms such as partnerships.

However, two Code provisions operate to prevent the use of the corporate form to unduly (in the eyes of the government) shelter accumulated earnings. These are the accumulated earnings tax (AET) under Secs. 531-537 and the personal holding company (PHC) tax under Secs. 541-547.

The AET is a 20% annual tax imposed on the accumulated taxable income of corporations. It applies to all corporations, unless an exception applies, that are formed or availed of for the purpose of avoiding the income tax by permitting earnings and profits (E&P) to accumulate instead of being distributed. Generally, the AET applies more broadly than the PHC tax because it is not limited to closely held corporations by stock ownership rules. However, under Sec. 534 the burden is generally on the government to prove that the corporation accumulated earnings and profits beyond its reasonable business needs (see, e.g., Advanced Delivery and Chemical Systems Nevada, Inc., T.C. Memo. 2003-250).

The PHC tax, as discussed in greater depth below, is also a 20% annual tax. It contrasts sharply with the AET in several respects, however, and for these reasons should be given careful consideration by any closely held business. First, and significantly, if the requirements of the PHC tax are met, it applies automatically — there is no "intent" element that the government must establish. Thus, if the stock ownership and income requirements discussed below are met, the corporation is a PHC regardless of whether the shareholders formed the corporation with the intent to shelter E&P. Second, if the PHC tax applies to a corporation, the corporation must self-assess the tax by filing Schedule PH (Form 1120), U.S. Personal Holding Company (PHC) Tax, with its income tax return for the year. Third, if the PHC fails to do so, it may be subject to penalties (such as accuracy-related penalties under Sec. 6662) and an extended six-year statute of limitation on assessment under Sec. 6501(f). Finally, if the PHC tax applies, the AET does not (Sec. 532(b)(1)).

The remainder of this discussion focuses on the application of the PHC tax in greater depth. It then concludes with some tax practice reminders to mitigate potential exposure to the applicability of the PHC tax.

Applicability of the PHC Tax

The PHC tax is a 20% tax imposed for each tax year on a PHC's undistributed personal holding company income (UPHCI). A PHC is a corporation that is not an excluded corporation and meets (1) the stock ownership requirement and (2) the income requirement. Excluded corporations include, for example, Sec. 501 tax-exempt organizations, banks, life insurance companies, and foreign corporations (Sec. 542(c)).

The stock ownership requirement is met if, at any time during the last half of the tax year, more than 50% of the value of the corporation's outstanding stock is owned, directly or indirectly, by five or fewer individuals. For these purposes, the following organizations are considered individuals:

• A qualified pension, profit sharing, or stock bonus plan described in Sec. 401(a);
• A trust described in Sec. 501(c)(17) that provides for the payment of supplemental unemployment compensation under certain conditions;
• A private foundation described in Sec. 509(a); and
• A part of a trust permanently set aside or exclusively used for the purposes described in Sec. 642(c) (Sec. 542(a)(2)).

Further, attribution rules under Sec. 544 provide that stock owned by an entity is considered as owned proportionally by its shareholders, partners, or beneficiaries and that an individual is considered as owning the stock owned by or for his or her family or by or for his or her partner. For these purposes, family includes only brothers and sisters, spouses, ancestors, and lineal descendants. Options to acquire stock as well as outstanding securities convertible into stock are considered to be outstanding stock under Sec. 544.

The income requirement is met if at least 60% of the corporation's adjusted ordinary gross income (AOGI) for the tax year is personal holding company income (PHCI). The first step in applying this percentage test is to determine AOGI by starting with gross income under Sec. 61 and then excluding gains from the sale or disposition of either capital assets or Sec. 1231(b) property (Sec. 543(b)(1)). Other adjustments are made, such as subtracting the amount of certain expenses related to rental income, the amount of expenses related to certain royalty income, and the amount of certain interest income (Sec. 543(b)(2)). The resulting amount is the corporation's AOGI for the year, and the income test under Sec. 542(a)(1) is met if 60% or more of the AOGI consists of amounts attributable to any of the following, as defined by Sec. 543(a):

• Dividends, interest, royalties (other than mineral, oil, or gas royalties or copyright royalties), and annuities;
• Rents;
• Mineral, oil, and gas royalties (subject to certain exceptions);
• Copyright royalties (subject to certain exceptions);
• Produced film rents;
• Compensation for use of corporate property by a shareholder;
• Amounts from personal service contracts; and
• Income from estates and trusts.

For each category, the Code and the regulations thereunder provide rules, including exceptions, that are beyond the scope of this discussion, that must be considered when making the income determination. The regulations related to the PHC tax, while helpful in some regards, are outdated in some other aspects, and therefore guidance in the area leaves some uncertainty in the interpretation of the rules.

If the PHC tax applies, it is equal to a 20% tax on the corporation's UPHCI under Sec. 545 — a different concept from PHCI under Sec. 543. UPHCI is determined by beginning with the taxable income of the corporation for the tax year and adjusting it for certain taxes paid, charitable contributions, net capital gains (with adjustment), and other items. The net operating loss (NOL) deduction under Sec. 172 for the current year is not allowed, but NOLs for the preceding year are allowed and are calculated without taking into account certain deductions including the corporate dividends-received and dividends-paid deductions (Sec. 545). The amount is then reduced by the dividends-paid deduction as defined in Sec. 561 to arrive at UPHCI (id.).

Tax practice reminders and best practices

The best result for any closely held corporation potentially subject to the PHC tax is that the tax simply does not apply because the corporation is not a PHC. Straightforward tax planning that properly accounts for the PHC rules can help avoid application of the PHC tax such as through careful consideration of incorporation with five or fewer shareholders, or stock ownership generally for the latter half of a tax year, always being mindful of the attribution rules under Sec. 544. Consideration of sources of PHCI under Sec. 543(a) can help guide investment choices.

If an analysis of the stock ownership and income requirements leads to the conclusion that a corporation is a PHC, one option to reduce or even eliminate the PHC tax is to timely pay dividends to shareholders such that UPHCI is reduced. Because the UPHCI determination under Sec. 545 is independent of the PHCI determination under Sec. 543, and because UPHCI is reduced by the dividends-paid deduction as defined in Sec. 561, payment of dividends to shareholders can reduce or entirely eliminate UPHCI.

Another best practice to consider if a corporation is a PHC, regardless of whether the corporation reduces UPHCI (even to the extent of having no PHC tax liability), is to file the required Schedule PH. This avoids extending the period of limitation on assessment under Sec. 6501(f), as the corporation is still properly reporting the existence of the PHC with its income tax return.

Take action to avoid the PHC tax

In contrast to the AET, which is assessed by the government, the PHC tax is self-assessed on Schedule PH. As discussed, this self-assessment can be prevented by ensuring the corporation either does not meet the stock ownership test or does not meet the PHC income test. Lastly, as the Code sections tax undistributed PHC income, a dividend payment can reduce or eliminate the tax.