@080 CHAP 8 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴커 � THE PERSONAL HOLDING COMPANY TAX ON CORPORATIONS � 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴켸 @Q "God must love the rich, or He wouldn't divide @Q so much among so few of them." -- H.L. Mencken @IF120xx] NOTE REGARDING @NAME: @IF120xx]旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴커 @IF120xx]쿍ecause your business isn't incorporated, the following dis-� @IF120xx]쿬ussion of personal holding taxes is not relevant to you un-� @IF120xx]쿹ess you are considering incorporation. � @IF120xx]읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴켸 @IF120xx] @IF118xx] NOTE REGARDING @NAME: @IF118xx]旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴커 @IF118xx]쿍ecause your corporation is an "S corporation," you do not � @IF118xx]쿴ave to be concerned with the personal holding company pen- � @IF118xx]쿪lty taxes discussed below, which apply only to "C" corpora-� @IF118xx]퀃ions, unless you are considering a change to "C" status. � @IF118xx]읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴켸 @IF118xx] The Personal Holding Company tax is a federal penalty tax on a corporation that is used by wealthy owners like an "incorporated pocketbook," to take advantage of corporate tax rates, or at least that was the theory behind the tax when it was enacted back in the 1930s, when corporate tax rates were much lower than individual tax rates. Now, since the Tax Reform Act of 1986 went into effect, corpor- ate tax rates rates are 6% HIGHER (maximum rates) than individual rates, so there would seem to be little reason to maintain this penalty tax. No matter. Once Congress enacts a tax law, we are stuck with it forever, usually. The personal holding company tax is now mainly a trap for the unwary, or for small corporations that can't afford good enough tax talent to keep them out of the clutches of this tax, rather than a measure to stop the rich from tak- ing advantage of a tax "loophole" by incorporating their stock portfolios or savings accounts. If a closely-held corporation gets a large proportion of its gross income, usually 60% or more, in the form of "personal holding company income" such as dividends, in- terest, rents, and royalties, it will generally be consid- ered a "personal holding company" (PHC) for tax purposes. Certain other non-passive kinds of income will also be con- sidered PHC income, such as income in a service business where anyone other than the corporation (the customer or client, for instance) has the right under a contract to designate the individual who is to perform the services, where the person designated owns at least 25% of the stock of the corporation. Also, payments a corporation receives from a 25% shareholder for use of its property is PHC in- come. This would put a damper on such schemes as having your corporation buy a yacht and charter it to you, for example. A corporation will only be considered a personal holding company if 5 or fewer people (including any stock that is "deemed" to be owned by them, through certain "tax relatives" or related businesses or trusts) are considered as owning more than 50% of the stock of the corporation in question. @IF110xx]------------------------------------------------------------- @IF110xx]NOTE: Because over 50% of the stock of your firm, a closely- @IF110xx]held C corporation, is held by 5 or fewer stockholders, there @IF110xx]is a distinct possibility (if it has substantial PHC income) @IF110xx]that your company could be subject to the personal holding @IF110xx]company penalty tax. Consult your tax adviser IMMEDIATELY if @IF110xx]you are not already sure about the personal holding company @IF110xx]tax status of @NAME. @IF110xx]------------------------------------------------------------- @IF110xx] @IF112xx]------------------------------------------------------------- @IF112xx]NOTE: Because your firm does not have 5 or fewer individuals @IF112xx]who own over 50% of its stock, it appears the PHC penalty tax @IF112xx]is not a problem for @NAME. @IF112xx]------------------------------------------------------------- @IF112xx] If a corporation comes within the definition of a personal holding company, the tax law imposes a 28% penalty tax on any PHC income that is not distributed as a dividend, as a general rule. This tax is IN ADDITION TO any regular cor- porate income tax the company pays. A company faced with the prospect of a PHC tax on its income often has little choice but to hastily declare a dividend of all of its net PHC income for the year before the end of its tax year. (An additional dividend of up to 20% of the dividends paid in the year just ended can be made within 2 1/2 months after the tax year ends, and treated as though distributed in the prior year, if the taxpayer so chooses.) The re- sult, of course, will still be double taxation, since the shareholders will be paying tax on income that has already been taxed once at the corporate level, for the most part. A more effective long-term approach for avoiding PHC tax is to have the corporation elect S corporation status, where that is possible, since an S corporation is not subject to the PHC tax. Of course, if the corporation has ineligible shareholders (such as corporations or non-resident alien individuals) or over 35 shareholders, for example, an S corporation election will not be allowed. Most actively conducted small businesses will not need to be very concerned about being treated as PHC's, since they will seldom get 60% or more of their gross income from passive sources like dividends and interest. The kind of small business most likely to have a PHC tax problem is the personal service business, where the corporation enters into contracts where it agrees to provide the services of an employee (such as a pro basketball player) who is a sole or major shareholder. The best way to avoid this problem is to specify in the contract that the corporation reserves the right to designate the person who will provide the ser- vices. You will need to consult your tax adviser before entering into any such personal service contract, however, since the tax rules in this area are quite subtle and the tax penalty is very heavy if the income under the personal service contract is considered to be "personal holding com- pany income." Another type of operating company that frequently encoun- ters PHC tax problems is the developer of computer software that generates much of its income from software licensing agreements. While the Tax Reform Act of 1986 included a special exemption from the PHC provisions for corporations actively engaged in the computer software business, the terms of this exception are quite technical and many soft- ware firms will not be able to qualify for this relief without very careful planning.