Avoiding Personal Holding Company Tax

What is a personal holding company?

A personal holding company (PHC) is a C corporation in which more than 50 percent of the value of its outstanding stock is owned (directly or indirectly) by five or fewer individuals and which receives at least 60 percent of its adjusted ordinary gross income from passive sources. Because the top corporate tax rates have historically been lower than the top individual tax brackets, some shareholders of closely held corporations have sought to retain earnings within the corporation as a strategy to avoid the higher individual tax rates. To prevent this, Congress enacted a penalty tax on certain C corporations–the personal holding company (PHC) tax.

The personal holding company tax is imposed on the undistributed income of those C corporations that serve as vehicles to shelter passive income. The rationale is that a corporation should be primarily an active business operation. The law targets those closely held corporations that derive substantial income from investments, such as royalties, interest, dividends, and rents. Avoiding PHC status is important because failure to do so could result in additional taxation. A PHC must pay a corporate tax equal to 20 percent. (From 2003 to 2012, the tax rate was 15 percent. The rate increased as of 2013 with passage of the American Taxpayer Relief Act of 2012). The tax is levied on undistributed PHC income.

To summarize, a personal holding company (PHC) is a C corporation in which:

  • At least 60 percent of the corporation’s adjusted ordinary gross income consists of PHC income
  • At any time during the last half of the tax year, more than 50 percent of the value of the corporation’s outstanding stock is owned, directly or indirectly, by (or for) five or fewer individuals

What is PHC income?

PHC income generally consists of the following sources of (primarily) passive income:

  • Dividends
  • Interest minus certain amounts excluded under Internal Revenue Code 543(a)(1) and Internal Revenue Code 543(b)(2)(C)
  • Royalties minus certain expenses allowed under Internal Revenue Code 543(b)(2)(B)
  • Annuities
  • Rents subject to specific income requirements
  • Compensation received for the use of corporate property from shareholders who own at least 25 percent of the value of the stock of the corporation, subject to limits
  • Amounts received under a personal service contract if someone other than the corporation designates the individual performing the services, and the person designated owns (directly or indirectly) at least 25 percent of the value of the corporation’s stock at least some time during the taxable year
  • Income from estates and trusts
  • Mineral, oil, gas, and copyright royalties subject to specific income requirements

What is PHC’s adjusted ordinary gross income?

In general, a PHC’s adjusted ordinary gross income is the corporation’s gross income, minus:

  • Gains from the sale or disposition of capital assets
  • Gains under Internal Revenue Code 1231(b)
  • Certain foreign income
  • Certain expenses allowed against rental income
  • Certain expenses allowed against royalty income
  • Certain interest income

See Internal Revenue Code 543(b) for more details.

Are there any exceptions to the definition of a personal holding company?

Some businesses that meet the general income and ownership tests for personal holding companies are statutorily excluded from PHC classification and taxation. These exceptions include the following:

  • Tax-exempt corporations
  • Banks
  • Domestic building and loan associations
  • Life insurance companies
  • Surety companies
  • Certain lending or finance companies
  • Certain foreign companies
  • Certain small business investment companies operating under the Small Business Investment Act of 1958
  • Corporations under the jurisdiction of the court in a Title 11 or similar bankruptcy case

What strategies can be used to avoid PHC taxation?

Throughout the year, corporations should monitor their accumulated earnings and the types of income they receive to detect potential exposure to the PHC tax. Certain strategies can be employed to avoid the tax.

Increase number of business owners

Since the PHC tax applies only to C corporations in which more than 50 percent of the value of stock is owned by five or fewer individuals during the last half of the tax year, you can avoid PHC status by ensuring that the top five owners in your closely held corporation own less than 50 percent of the value of the outstanding stock. Gifts of stock to relatives or friends can avoid potential problems in this area.

Bear in mind, though, the concept of “constructive ownership.” Stock owned directly or indirectly by your family members and certain other related individuals or entities could be treated as owned by you. Your family members include your brothers and sisters, your spouse, ancestors, and lineal descendants. You can, for instance, gift stock to the spouse of your brother or sister.

Increase adjusted ordinary income or decrease PHC income

Since you are only subject to the PHC tax if at least 60 percent of the corporation’s adjusted ordinary gross income consists of PHC income, you should change the relationship between your operating income and your passive investment income. More specifically, you can take steps to increase your adjusted ordinary income or to decrease PHC income.

To increase adjusted ordinary income:

  • Accelerate sales and bill at year-end
  • Decrease cost of goods sold by deferral of purchases or other expenses at year-end
  • Invest in other business activities that result in additional gross receipts that are not PHC income

To decrease accumulated PHC income:

  • Cash in some securities and reinvest the funds in stocks that have growth potential but do not regularly pay dividends
  • Pay dividends to stockholders (dividends can even be paid 2½ months after year-end if you make a special election)
  • Limit your passive investments

Can converting from a C corporation to an S corporation help?

While the PHC tax is only imposed on C corporations, election of S status may not be an effective solution. An S corporation that has prior C corporation earnings and profits (E&P) and more than 25 percent of its gross receipts from PHC income sources is also exposed to a tax. A corporate level tax of 35 percent is levied on the excess net passive income.