Legal Definitions - personal-holding-company tax

The personal-holding-company tax is an additional tax imposed by the government on certain types of closely held corporations. This tax is specifically designed to prevent individuals from using a corporation primarily to hold passive investments (such as stocks, bonds, or real estate) and accumulate income within that corporation, thereby avoiding higher individual income tax rates that would apply if the income were received directly.

For a corporation to be subject to this tax, it generally must meet two main criteria:

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

If a corporation meets both of these conditions, the personal-holding-company tax is applied to its undistributed personal holding company income, in addition to its regular corporate income tax. The purpose is to encourage these companies to distribute their earnings to shareholders, where they will then be taxed at individual income tax rates.

Here are some examples to illustrate how this tax applies:

• Example 1: Family Investment Company

  A family of four creates a corporation, "Wealth Builders Inc.," to manage their extensive portfolio of stocks and bonds. The family members collectively own 100% of the shares. In a given year, Wealth Builders Inc. earns substantial income solely from dividends and interest generated by its investments. The family decides to retain most of these earnings within the corporation rather than distributing them as dividends to themselves, hoping to defer their personal income tax obligations.

  How it illustrates the term: Wealth Builders Inc. would likely meet the ownership test because five or fewer individuals (the four family members) own all its stock. It would also meet the income test because 100% of its income comes from passive sources (dividends and interest). If the company does not distribute its income, it would be subject to the personal-holding-company tax on its undistributed earnings, encouraging the family to pay out the income and face individual taxation.

• Example 2: Real Estate Rental Business

  Three friends establish "Prime Properties LLC" (taxed as a corporation) to purchase and manage several commercial rental properties. The friends are the sole owners of the company. The primary source of income for Prime Properties LLC is rent collected from its tenants. They decide to accumulate a large portion of the rental profits within the company for future property acquisitions, rather than distributing the money to themselves.

  How it illustrates the term: Prime Properties LLC would satisfy the ownership test as only three individuals own all the shares. If the rental income, after certain adjustments, constitutes 60% or more of the company's adjusted ordinary gross income, it would also meet the income test. Consequently, if the company does not distribute its earnings, it could be classified as a personal holding company and face the additional personal-holding-company tax on its undistributed income.

• Example 3: Artist's Service Corporation

  A renowned graphic designer, Ms. Anya Sharma, forms "Anya Designs Inc." to handle all her professional engagements. Ms. Sharma is the sole shareholder. Anya Designs Inc. enters into contracts with clients where Ms. Sharma's specific design services are explicitly designated, and the clients have the right to require her personal services. The corporation receives significant fees and royalties from these contracts. Ms. Sharma chooses to keep a large portion of these earnings within the corporation.

  How it illustrates the term: Anya Designs Inc. clearly meets the ownership test as Ms. Sharma is the sole owner. Certain income from personal service contracts, where a 25% or more shareholder is designated to perform the services and the client has the right to demand those services, can be considered passive income for personal holding company purposes. If this type of income makes up 60% or more of the company's adjusted ordinary gross income, and the company accumulates its earnings, Anya Designs Inc. could be subject to the personal-holding-company tax.