The PHC trap. (personal holding company) (Federal Taxation)by Cuiffo, Donna-Marie
The personal holding company provisions were originally intended to prevent individual taxpayers from using closely-held corporations to avoid individual income taxes on investment and other specific types of income. This used to be a very appealing situation when the top individual tax rate was significantly higher than the top corporate rate. After TRA 86, the tax rate advantage was lost since the top individual rate became lower than the top corporate rate. However, it should be remembered that the lowest corporate rate (15%) is substantially lower than the top individual rate (31%). Special care should be taken when working with CHCs set up for other than investment reasons because unsuspecting practitioners can get caught in the PHC trap.
The Rules to Be a PHC
Each C corporation is responsible for determining whether it is a personal holding company. A schedule PH must be attached to the PHC's return. If the schedule is not filed, the statute of limitations on the assessment of PHC tax is extended from the usual three years to six years.
A PHC is subject to the regular corporate income tax plus an additional tax of 28% of the undistributed personal holding company income. Since these tax liabilities could become substantial, the taxpayer and its advisors should review each CHC before year end so that steps may be taken to assure that the corporation does not owe the personal holding company tax.
Example. The rental of a commercial building is the sole business of a newly formed closely-held corporation. For the first three years, the corporation reported a loss from the activity. Due to Sec. 469 limitations, the loss was suspended and carried forward. Therefore, no net operating loss carryforward exists. In year four, the shareholders contributed additional money to the corporation for various improvements. For one reason or another, the improvements were not started in year four, so the money was put into a brokerage account. During the year, the corporation earned interest income of $50,000. In the same year, the rental activity had a net rental loss of $20,000 (rental income of $200,000, property taxes of $30,000, depreciation of $170,000, and other expenses of $20,000). The corporation did not pay any dividends during year four. The corporation has a passive rental real estate loss of $20,000, none of which can be used to offset the interest income because of the Sec. 469 limitations. The $20,000 passive loss is suspended and carried forward to future years. The corporation will pay a regular corporate tax of $7,500 plus a PHC tax of $11,900 on the $50,000 of interest income. The PHC tax of $11,900 is calculated by taking 28% of the undistributed PHC income of $42,500 ($50,000 - Federal tax of $7,500).
How the PHC Tax Operates
There are two criteria for determining whether a C corporation is a PHC:
Stock Ownership Test. Five or fewer persons own more than 50% of the value of the corporation's stock.
Gross Income Text. At least 60% of the adjusted ordinary gross income is personal holding company income.
Constructive ownership rules are provided by the IRC to prevent the avoidance of the stock ownership test by the mere creation of additional entities. For the gross income test, Sec. 543 refers to the section defining gross income Sec. 61 for the determination of what constitutes ordinary gross income.
Adjusted gross income is calculated by making the following adjustments provided by Sec. 543(b):
1. Rental income is reduced (not below zero) by rent expense, property taxes, interest and amortization allocable to the rented property, and depreciation. In our example, the rental income of $200,000 would be reduced by $30,000 of property taxes and $170,000 of depreciation. Therefore, the total adjusted ordinary gross income in our example is $50,000 of interest income.
2. Mineral oil and gas royalties are reduced (not below zero) by depletion, property or severance taxes, interest and rent allocable to the property producing such income.
3. Interest income on judgments, tax refunds, and condemnation awards is excluded.
Personal holding company income consists of the following:
* Dividends, interest (except as described above), royalties, and annuities;
* Adjusted income from rents (gross income from rents (with some limitations) reduced by depreciation, property taxes, interest, and rent but not in excess of gross rents);
* Adjusted income from mineral, oil, and gas royalties (with some exceptions);
* Copyright royalties (with exceptions);
* Produced film rents (with exceptions);
* Compensation for the use of property if at any time during the tax year 25% or more of the corporation's stock is owned, directly or indirectly, by an individual entitled to the use of the property; and
* Amounts received under a contract for personal services rendered by an individual who owns 25% or more of the corporation's stock.
Rental income will not be considered PHC income if the rental income totals at least 50% of adjusted ordinary gross income and the sum of dividends paid, dividends considered paid, and consent dividends is at least equal to the amount by which other personal holding company income exceeds 10% of ordinary gross income.
Since, in our example, PHC income ($50,000 interest income) is more than 60% of adjusted ordinary gross income, the CHC is a PHC. Since no dividends were paid, it would appear that the corporation has been caught in the PHC trap.
There are ways to correct the situation. The most obvious ways are to either disqualify the corporation under either the stock ownership test or the gross income test by deferring or accelerating specific types of income. Although these methods will result in no PHC tax, they are not always practical.
Since the PHC tax is assessed on undistributed PHC income, a payment of a dividend will eliminate the tax. If a projection of taxable income can be made reasonably accurate, the corporation may take steps to pay dividends by the year end. If a PHC problem is discovered after year end, the corporation may still solve the tax problem since the dividends-paid deduction includes dividends paid on or before the 15th day of the third month following the end of the tax year. In order for these "post-year" dividends to be deductible, they may not exceed the lessor of the undistributed personal holding company income for the prior tax year or 20% of the dividends paid during the prior tax year. Therefore, due to the 20% limitation rule, if no dividends were paid during the prior tax year, no post-year dividends will be deductible.
If the corporation cannot deduct the post-year dividends, it may choose to have the shareholders file for a consent dividend provided the consents are filed any time before the due date of the corporation's income tax return. A consent dividend is an amount the shareholders agree to report as dividends even though not received by them.
The dividend carryover (the excess of the dividends paid in the prior two years over the taxable income for such years) may also be considered as part of the dividend deduction.
If a PHC tax deficiency is assessed because of a bona fide difference of opinion with the IRS relating to an amount of income or deduction, there is a relief provision that permits the taxpayer to escape the PHC tax by the payment of a deficiency dividend. There are certain limitations as to the application of this relief provision which should be reviewed carefully. The relief provision is not available if any part of the deficiency is due to fraud with intent to evade tax or to willfully fail to file a timely income tax return.
Because of preparer penalties, it is very important to examine each situation annually. CHCs set up with purposes other than to be investment conduits must stay alert to the fact that some year they might be caught in the PHC trap.
Donna-Marie Cuiffo, CPA, Wessbarth, Altman & Michaelson
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