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Warning
In addition to any other taxes imposed by under the Code, Code Section 541 imposes a personal holding company tax at the rate of 39.6 percent on the
"undistributed personal holding company income" (as defined in Code Section 545 ) of every "personal holding company" (as defined in Code Section 542 ).
The personal holding company tax is designed to prevent taxpayers from achieving unwarranted individual income tax deferral through the use of corporations to
carry on essentially "personal" activities. By imposing a significant additional tax on the corporation for its undistributed income, the tax encourages corporations to
make distributions to shareholders rather than accumulate earnings.
Due to the potentially large impact of this tax -- and the costly litigation that certainly could
accompany it -- practitioners should plan to avoid its imposition at the outset by understanding its requirements.
When the maximum corporate income tax rate is lower than the maximum individual rate, the corporate form can be used to reduce individual income taxes. The
personal holding company tax provisions are aimed at three different schemes, all of which depend on the lower rates of taxation for corporations than for individuals
as well as the accumulation of earnings in the corporation to avoid the double tax:
(1) Many taxpayers transfer stocks, bonds, or other income-producing assets to a corporation, making the corporation the so-called incorporated pocketbook
subject to lower rates of taxation as long as income remains in the corporation;
(2) individuals with unique talents, such as consultants or entertainers, might form a corporation that would then contract with the shareholder to perform services
for third parties. The corporation would receive large amounts of income, but would pay the shareholder a relatively modest salary. The difference would
accumulate in the corporation at the relatively low corporate tax rates; or
(3) a shareholder might contribute property such as a yacht or country estate to a corporation with investment income. The corporation would then lease the
property to the shareholder, reporting rental income, but would also deduct the usual business expenses associated with the operation of such property. The overall
transaction results in a loss that could be used to offset the corporation's investment income, resulting in no tax at the corporate level and essentially a deduction for
the personal expenses of the taxpayer.
Even though the accumulated earnings tax existed to reach such schemes, Congress felt that the subjective nature of the business purpose inquiry prevented that tax
from effectively combating these types of abuses. As a result, Congress fashioned a new surtax, the "personal holding company tax," to be imposed on the
"undistributed personal holding company income" of certain corporations. This surtax acts as an additional disincentive to the use of a corporation to achieve
deferral.
The personal holding company tax differs from the accumulated earnings tax in two important ways. First, by adopting a strictly objective approach to determining
liability for the tax, the personal holding company provisions avoid the subjective business purpose inquiry that has proven so troublesome in the accumulated
earnings tax arena. Instead, a corporation that meets the stock ownership and income requirement tests will be subject to the personal holding company tax on its
undistributed personal holding company income. The intent to avoid or reduce tax is irrelevant. American Package Corp. v. Commissioner, 125 F.2d 413 (4th Cir.
1942), aff'g 44 B.T.A. 179 (1941).
These two tests and the calculation of undistributed personal holding company income are discussed in Section 211.2 and Section 211.3 Second, the personal
holding company provisions are clearly designed to compel distributions from the corporation rather than to impose the tax. The methods for making dividend
distributions from personal holding companies take on major importance in avoiding imposition of the tax.
Corporations meeting the income and stock ownership requirements are considered personal holding companies for purposes of this tax. There are, however,
exceptions to this definition. The term "personal holding company" does not include a tax-exempt corporation, a bank or domestic building and loan association, a
life insurance company, a surety company, a foreign personal holding company, certain lending or finance companies, certain foreign corporations, certain small
business investment companies, a corporation in bankruptcy, or a passive foreign investment company. Code Section 542(c). Thus, even if one of these entities
meets the income and stock ownership requirements, it is not considered a personal holding company and is not subject to the personal holding company tax.
Since the current maximum corporate rate is only slightly lower than the maximum individual rates, it appears unlikely that corporations will be widely used to shelter
income from high individual rates. Additionally, the enactment of Code Section 311, which requires a corporate level tax on the distribution of assets from the
corporation, serves as a significant disincentive for this type of planning. However, these tax planning strategies may remain important in some situations, and
the personal holding company tax provisions in the Code constitute a continuing trap for the unwary. As a result, it is necessary for the
practitioner to be familiar with these provisions.
Plain English definitions for the following: (1) a closely held
corporation, (2) a personal holding corporation, and (3) a personal
service corporation
Generally, a closely held corporation is
a corporation that, in the last half of the tax year, has more than 50%
of the value of its outstanding stock owned (directly or indirectly) by
5 or fewer individuals. The definitions for the terms "directly or
indirectly" and "individual" are in Publication
542, Corporations. Generally, closely held corporations are subject
to additional limitations in the tax treatment of items such as passive
activity losses, at-risk rules, and compensation paid to a corporate
officers.
A personal holding company is defined in
Internal Revenue Code section 542. Basically, a corporation is a
personal holding company if both of the following requirements are met:
- Personal Holding Company Income Test.
At least 60% of the corporation's adjusted ordinary gross income for
the tax year is from dividends, interest, rent, and royalties.
- Stock Ownership Requirement. At any
time during the last half of the tax year, more than 50% in value of
the corporation's outstanding stock is owned, directly or
indirectly, by 5 or fewer individuals.
Refer to the Instructions
to Form 1120, Schedule PH for more information and a list of
exceptions.
A personal service corporation is a
corporation where the main work of the company is to perform services in
the fields of health, law, engineering, architecture, accounting,
actuarial science, the performing arts, or consulting. Examples may be
law firms and medical clinics. Also, substantially all of the stock is
owned by employees, retired employees, or their estates.
References:
Engagement
Status Letter ~ WARNING!
 
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