A closely-held corporation that accumulates investment income such as interest, dividends, and certain royalties within the corporation and does not distribute the income to the shareholders could potentially be subject to the personal holding company tax. The purpose of the tax is to prevent shareholders from accumulating income in a corporation to avoid paying individual income tax on distributions of the income.
The personal holding company tax applies to a C corporation, not an S corporation or limited liability company (LLC). A corporation would be considered a personal holding company if five or fewer shareholders directly or indirectly own more than 50% in value of the company’s outstanding stock at any time during the last half of the year, and 60% or more of the corporation’s adjusted ordinary gross income is personal holding income.
According to the IRS, personal holding income includes dividends; interest; mineral, oil, and gas royalties; copyright royalties; other types of royalties; annuities; rents; produced film rents; compensation received for the use of the corporation’s property by a shareholder with an interest of 25% or more; amounts received under personal service contracts or income from the sale of those contracts; and taxable amounts from trusts and estates.
As pointed out in the Business Owner’s Toolkit, there are various exceptions to what income constitutes personal holding income and the calculation can be complicated.
Walter E. Daniels of Ward & Smith, P.A. explains on the WRALtechwire website that the personal holding company tax was originally enacted when personal income tax rates were above 70% in some cases, and closely-held corporations were used to shelter investment income from those high individual rates. The purpose of the personal holding company tax, which has historically been at a higher rate than the current 15%, was to penalize this activity.
As indicated by Cho Chan CPA, Inc., there are various situations that could potentially trigger the personal holding company tax. For example, a closely-held corporation that receives a significant amount from an insurance settlement and invests the money until replacement property is purchased could be subject to the tax. Or if a company sells a line of business and invests the proceeds until it acquires or starts up a new line of business the personal holding company tax could be triggered.
Generally, if the majority of a closely-held corporation’s income comes from the active conduct of its business, the personal holding company tax would not apply. But if a significant amount of income comes from investments outside the company’s principal line of business, and that income is not distributed to the shareholders, the tax could potentially apply.
The personal holding company tax is imposed on the undistributed personal holding income. This tax is added to the regular corporate income tax. If the personal holding company tax applies, Schedule PH (Form 1120), U.S. Personal Holding Company (PHC) Tax, must be filed with the corporate income tax return.
Sources:
Instructions for Schedule PH (Form 1120), IRS
Personal Holding Company Tax, Business Owner’s Toolkit
Personal holding company unsuspecting tax traps, Cho Chan CPA, Inc.
Schedule PH (Form 1120), U.S. Personal Holding Company (PHC) Tax
Walter E. Daniels, Ward & Smith, P.A., The Personal Holding Company Tax: A Potential Trap for Early Stage High Tech Companies, WRALtechwire