If a closely‑held corporation earns a lot from passive investments rather than active business operations, it can run into the personal holding company (PHC) tax. Under § 541, a PHC is subject to a 20% penalty tax on its undistributed personal holding company income.
When does a corporation become a PHC? Two main tests:
- It is closely‑held as defined in § 542(a)(2).
- At least 60% of its “adjusted ordinary gross income” comes from “personal holding company income” (mostly investment income like dividends, interest, rents, and royalties). § 543(a).
The purpose, as the Supreme Court explained, is “to force corporations which are ‘personal holding companies’ to pay in each tax year dividends at least equal to the corporation’s undistributed personal holding company income.” Fulman v. United States, 434 U.S. 528, 531 (1978). By paying out the income as dividends, the corporation avoids the penalty tax. But paying out that income means shareholders recognize dividend income – which, before the TCJA, could be taxed at higher individual rates. The TCJA’s lower corporate rate has made the PHC tax a more significant consideration for investment‑heavy corporations.
I’ve seen many business owners surprised when their once‑active business starts generating mostly passive income and trips the PHC rules. The key is to keep an eye on your income mix as your business evolves.
This article is for general informational purposes only and is subject to change. Tax laws are complex and vary by situation. You should consult a qualified professional for advice specific to your circumstances. For questions, contact Alan Goldstein.
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