Legal Definitions - personal holding company

A personal holding company is a specific type of corporation that the U.S. tax law identifies based on two main characteristics:

• Ownership: More than 50% of its stock is owned, directly or indirectly, by five or fewer individuals at any time during the last half of the taxable year.
• Income: At least 60% of its adjusted ordinary gross income comes from passive sources, such as dividends, interest, rents, royalties, or certain personal service contracts.

The purpose of this classification is to prevent wealthy individuals from using a corporation to shelter passive investment income from higher personal income tax rates. If a company is classified as a personal holding company and does not distribute a significant portion of its earnings to shareholders, it can be subject to a substantial penalty tax on its undistributed income.

Examples:

• Investment Portfolio Management:

  Scenario: Mr. David Chen, a retired entrepreneur, has a large portfolio of stocks, bonds, and mutual funds. To simplify his estate planning, he incorporates "Chen Family Investments Inc." The corporation's income consists almost entirely of dividends, interest, and capital gains from these investments. Mr. Chen and his two adult children are the only shareholders.

  Illustration: "Chen Family Investments Inc." is owned by fewer than five individuals (Mr. Chen and his two children), and its income is predominantly from passive investment sources. This structure fits the definition of a personal holding company. If the corporation does not distribute most of its investment income to the shareholders, it could face the special personal holding company penalty tax.

• Real Estate Rental Business:

  Scenario: The Rodriguez family owns several commercial properties that they rent out to various businesses. They have organized these properties under "Rodriguez Property Management LLC," which has elected to be taxed as a corporation. The LLC's primary income is derived solely from rent payments from its tenants. The five members of the Rodriguez family are the only owners.

  Illustration: "Rodriguez Property Management LLC" is closely held by five individuals, and its main source of income is passive rent. If the rental income constitutes 60% or more of its adjusted ordinary gross income, it could be classified as a personal holding company. Consequently, any undistributed rental profits could be subject to the personal holding company penalty tax.

• Intellectual Property Holding:

  Scenario: Dr. Emily White, a brilliant scientist, developed several patented technologies. She formed "White Innovations Corp." to hold the patents and license them to other companies. The corporation's income is almost exclusively from the royalties paid by these licensees. Dr. White is the sole shareholder.

  Illustration: "White Innovations Corp." is owned by a single individual (Dr. White), and its income is entirely from passive royalties. This scenario strongly suggests it would be classified as a personal holding company. To avoid the penalty tax, Dr. White would need to ensure the corporation distributes a significant portion of its royalty income to her as dividends.