Sec. 541: A trap for the unwary investment partnership

Editor: Jeffrey N. Bilsky, CPA

Sec. 541 imposes a 20% tax on the undistributed personal holding company income of a personal holding company. Initially enacted in 1934, the tax was intended to discourage individuals from using closely held corporations as tax shelters for investment income. However, given that current long–term capital gains rates are less than the corporate tax rate, the problem Sec. 541 was intended to address no longer exists. Nevertheless, Sec. 541 remains a part of the Code and therefore must be confronted where it may apply, including in the case of investment partnerships that may unwarily become subject to the regime.

What is a personal holding company?

Under Sec. 542, a personal holding company is any corporation (other than certain excluded corporations) if the corporation meets both the income and stock ownership tests defined in the statute. The income test is met if at least 60% of the corporation’s adjusted ordinary gross income (as defined in Sec. 543(b)(2)) for the tax year is personal holding company income (Sec. 542(a)(1)). Pursuant to Sec. 543, personal holding company income includes dividends, interest, royalties, and annuities. If a corporation is part of a consolidated group of corporations, then the income test is applied to the consolidated gross income of the group. The test is applied on a member–by–member basis if any member of the affiliated group of corporations filing or required to file a consolidated return under Sec. 1501 derived 10% or more of its adjusted ordinary gross income from sources outside the affiliated group and 80% or more of that income consists of personal holding company income (Sec. 542(b)(2)).

The stock ownership test is met if at any time during the last half of the tax year more than 50% in value of the outstanding stock of the corporation is owned, directly or indirectly, by or for not more than five individuals (Sec. 542(a)(2)). Pursuant to Sec. 544, stock owned by a corporation, partnership, estate, or trust shall be considered as being owned proportionately by its shareholders, partners, or beneficiaries. An individual shall also be considered as owning the stock owned by their “brothers and sisters …, spouse, ancestors, and lineal descendants.” Therefore, Sec. 544 applies sideways attribution among members of the same partnership (Secs. 544(a)(1) and (2)).

Example of application of Sec. 541 to an investment partnership

The application of the income and stock ownership tests — and a potential trap for the unwary — is clear in the following example:

Example: Partnership P owns 100% of the stock of corporation C. C is the parent of a consolidated group with two subsidiaries, S1 and S2. S1 holds all of the domestic operations of the consolidated group, and S2 is the holding company of a foreign subsidiary. C has taken on third–party debt and has loaned cash to S1. S1 has ordinary gross income in year 1 of $190 million. C’s only income in year 1 is $5 million of interest relating to the intercompany receivable. Also in year 1, S2 has $5 million of royalty income relating to patents it allows its foreign subsidiary to use.

P has five individual partners who collectively hold 10% of the partnership interest of P, and an investor partnership holds the remaining 90%. The investor partnership has 100 partners, none of whom owns greater than 1% of P. None of the aforementioned individuals are family members for purposes of Sec. 544(a)(2).

Thus, the structure is as shown in the diagram “Application of Income and Ownership Tests.”

As S2′s only income is from outside the group and all of such income consists of personal holding company income, the income test must be applied on a member–by–member basis. C’s only income is $5 million of interest income, which is personal holding company income. Therefore, the income test is met with respect to C, as greater than 60% of C’s adjusted ordinary gross income is holding company income.

Additionally, because P owns all of the stock of C, P’s partners would be treated as owning their proportionate share of C stock under Sec. 544(a)(1). Each individual partner of P would further be considered as owning all of the shares constructively owned by their partners under Sec. 544(a)(2). If Investor Partnership is considered a partner for this purpose, then each individual partner of P would be considered as owning 100% of C. Similarly, the partners of Investor Partnership would be treated as owning their proportionate share of the 90% of C stock attributed to Investor Partnership under Sec. 544(a)(1). Then, under Sec. 544(a)(2), each individual partner of Investor Partnership would be considered as owning the stock owned by their partners. As a result, each individual partner of Investor Partnership would be considered as owning 90% of C. Thus, the ownership test is met with respect to P, as each of the five partners would be considered as owning 100% of C, and each partner of Investor Partnership would be considered as owning 90% ofC.

C’s taxable income is $200 million. Under Sec. 542(b)(2), the determination of whether the income test is met shall be applied at the member–by–member level if the affiliated group is an ineligible affiliated group. However, Sec. 545 does not include a similar exception to determine the undistributed personal holding company income on a member–by–member level. Therefore, the undistributed personal holding company income of C is $158 million ($200 million − [$200 million × 21%]). Under Sec. 541, C would be required to pay $31.6 million in tax and would not receive a credit for any future distributions.

Potential solution to prevent application of Sec. 541

Sec. 541 will not apply if the income test or the ownership test is not met. In this situation, if S1 and S2 are treated as disregarded, then the income test would not be met, and Sec. 541 would not apply. However, with larger consolidated groups and without constant monitoring, it may be difficult to ensure the income test is not met. As such, it may be less burdensome to structure the upper–tier ownership so that the ownership test is not met.

One way to potentially prevent Sec. 541 from applying to the above example is to require individual partners to invest through an S corporation. Pursuant to Sec. 544(a)(1), vertical attribution applies proportionately to the S corporation shareholders, but no horizontal attribution occurs between the S corporation shareholders. Thus, the five individual shareholders would be treated as owning 2% of C. In addition, the 100 partners invested in Investor Partnership would also need to invest through an S corporation to avoid each of the partners constructively owning 90% ofC.

Rather than requiring investors to invest through S corporations, the same result can be obtained by requiring the individual investors to invest through a series of partnerships. The horizontal attribution rule of Sec. 544(a)(2) applies to individuals who are partners in the same partnership. If the five partners invested in P through another upper–tier partnership, Sec. 544(a)(2) would not attribute the 90% interest of Investor Partnership to the upper–tier partnership. Furthermore, if no partnership constructively holds 50% or more of the stock of a C corporation, then Sec. 544(a)(2) will not cause the ownership test to be met.

The IRS’s interpretation in Letter Ruling 201208025

The IRS viewed the Sec. 544(a)(2) attribution rules differently in Letter Ruling 201208025. In the ruling, the taxpayer was a parent of a consolidated group held by the public and a series of corporations, partnerships, and organizations. In finding that the taxpayer was not a personal holding company, the IRS stated that:

When stock of a potential personal holding company is owned by a partnership, corporation, estate, or trust, [Sec.] 544(a)(1) provides that it is treated as being owned proportionately by its shareholders, partners, or beneficiaries. This language excludes these entities from being considered to be the owner of the potential personal holding company stock, and attributes any direct or indirect interest in the potential personal holding company only to individuals.

Thus, according to Letter Ruling 201208025, horizontal attribution under Sec. 544(a)(2) does not apply to partnerships if vertical attribution under Sec. 544(a)(1) is required.

Private letter rulings are specific to the taxpayer requesting such ruling. Additionally, since 2015, the IRS will no longer issue rulings with regard to Secs. 542, 543, and 544. Furthermore, Sec. 544(a)(5) uses the word “person” to refer to partnerships, which is not entirely consistent with the IRS’s stated view in Letter Ruling 201208025. Although the ruling provides a useful argument for taxpayers, it does not necessarily eliminate the trap presented under Sec. 541 for the unwary tax practitioner.

Editor Notes

Jeffrey N. Bilsky, CPA, is managing principal, National Tax Office, with BDO USA LLP in Atlanta.

For additional information about these items, contact Bilsky at jbilsky@bdo.com.

Contributors are members of or associated with BDO USA LLP.