Personal Holding Company Tax: IRC Section 541 CPA REG Guide

Personal Holding Company Rules Under IRC Section 541

The personal holding company (PHC) tax is a penalty tax imposed on certain closely held C corporations that earn primarily passive income. Like the accumulated earnings tax, the PHC tax is designed to prevent individuals from using corporations as "incorporated pocketbooks" to defer or reduce taxation on investment income. Unlike the AET, however, the PHC tax is based on objective mechanical tests rather than subjective intent. For CPA REG candidates, the PHC rules require precise application of the stock ownership test and the income test.

The Two-Part Test

Stock Ownership Test

A corporation meets the stock ownership test if, at any time during the last half of the taxable year, more than 50% in value of its outstanding stock is owned, directly or indirectly, by five or fewer individuals. Constructive ownership rules under Section 544 apply, which attribute stock owned by family members (siblings, spouse, ancestors, lineal descendants), partners, and certain entities to individuals. These attribution rules are very broad and can cause corporations with seemingly dispersed ownership to meet the test.

Income Test

A corporation meets the income test if at least 60% of its "adjusted ordinary gross income" (AOGI) consists of "personal holding company income" (PHCI). AOGI is gross income minus certain deductions directly related to the production of that income (such as rental expenses and depreciation on rental property). The key types of PHCI include:

Dividends, interest, royalties, and annuities: These are PHCI regardless of the source or amount.
Rents: Rental income is PHCI unless it constitutes 50% or more of AOGI and the corporation distributes dividends equal to the excess of non-rental PHCI over 10% of ordinary gross income. This exception allows legitimate rental companies to avoid PHC status.
Mineral, oil, and gas royalties: These are PHCI unless they constitute 50% or more of AOGI and the corporation meets certain distribution requirements.
Personal service contracts: Amounts received under personal service contracts are PHCI if a person other than the corporation has the right to designate the individual who is to perform the services and that individual owns 25% or more of the corporation's stock.
Copyright royalties: These are PHCI unless they constitute 50% or more of ordinary gross income and other conditions are met.

Computing the PHC Tax

Undistributed PHC Income

The PHC tax is 20% of "undistributed personal holding company income." This amount is computed starting with taxable income, then making adjustments including: subtracting federal income taxes, subtracting the net capital gain minus the tax attributable to that gain, adding back certain deductions that are not allowable for PHC purposes (such as excess charitable contributions), and subtracting the dividends-paid deduction.

Dividends-Paid Deduction

Like the AET, the PHC tax can be reduced or eliminated by paying dividends. The dividends-paid deduction includes regular dividends paid during the year, consent dividends, and liquidating distributions. A corporation can also use the "deficiency dividend" procedure under Section 547, which allows dividends paid after the PHC tax has been determined (or even asserted by the IRS) to retroactively reduce or eliminate the tax. The deficiency dividend must be paid within 90 days of the determination and claimed by filing a form with the IRS.

Exempt Corporations

Certain corporations are specifically exempt from the PHC tax, including S corporations, tax-exempt organizations, banks and financial institutions, life insurance companies, surety companies, lending and finance companies, and foreign personal holding companies (which are subject to different rules). A corporation subject to the PHC tax is exempt from the accumulated earnings tax for that same year.

Planning Considerations

Corporations at risk of PHC classification have several strategies: increase active business income to dilute the PHCI percentage below 60%, pay sufficient dividends to eliminate undistributed PHC income, convert to S corporation status (S corps are exempt), ensure rental income qualifies for the rental exception by meeting the 50% threshold and distribution requirements, or restructure ownership to avoid the stock ownership test (though constructive ownership rules make this difficult).

CPA Exam Strategies

Apply both tests: stock ownership (more than 50% owned by 5 or fewer individuals) AND income (60% of AOGI is PHCI).
Remember the constructive ownership rules under Section 544 for the stock test.
Know the rental income exception (50% of AOGI plus distribution requirement).
The PHC tax rate is 20% on undistributed PHC income.
The deficiency dividend procedure is a unique escape valve not available for the AET.
PHC tax and AET are mutually exclusive.