Accumulated Earnings and Deferred Compensation

Personal Holding Company Tax

The Personal Holding Company (PHC) tax was developed to penalize the sheltering of certain types of passive income in C corporations that are formed by high-income individuals solely for the purpose of owning the stock of other companies. These corporations are often called "corporate pocketbooks" because they store what would otherwise be individuals’ income.

The government discourages this practice in certain circumstances, so it devised the concept of a Personal Holding Company.

A corporation is a Personal Holding Company if two criteria are met:

1. Stock Ownership Test: more than 50% of the value of the outstanding stock is owned directly or indirectly by 5 or fewer individuals during the last half of the taxable year. It is not the number of shares that counts, but the market value of the shares.

   Constructive Ownership Rules: The following broad constructive ownership rules apply to the determination of the total ownership position of an individual:

   • Stock owned by a corporation, trust, partnership or estate is owned proportionately by the shareholders, partners or beneficiaries
   • Stock owned by members of an individual's family or partner is considered owned by the individual
   • An option to purchase stock is regarded as owned stock
   • Convertible securities are treated as outstanding stock

   Here are examples...

   ABC Company has 10 owners on January 1, each owning 10% of the stock. On October 25, one of the owners sells her stock to another one of the owners. The result is 9 owners with 5 owning 60%. The ownership test has been satisfied

   Company XYZ has four owners: L owns 40%, M owns 20%, N owns 30%, and O owns 10%. Since fewer than five owners hold greater than 50% of the total value of the stock, the ownership test has been satisfied.

2. Gross Income Test: a substantial portion (60% or more) of the corporate adjusted ordinary gross income for the tax year is derived from passive forms of income.

   To satisfy the gross income test, 60% or more of the corporation's adjusted ordinary gross income (AOGI) must consist of certain passive income sources that include:

   • Dividends, interest, adjusted rents, annuities, and royalties
   • Trust and estate income
   • Other royalties including those from oil, gas, and minerals
   • Income from a business in which the taxpayer does not materially participate
   • The amount received from a personal service contract is classified as PHC income if:
     1. Some person other than the corporation has the right to designate, by name or description, the individual who is to perform the services
     2. The person so designated is a 25% or more shareholder

   The formula for the gross income test is

   Passive Income	=   60% or more
   AOGI

Coverage

A PHC is a C corporation and as such the PHC tax does not apply to the following:

• S corporations
• Tax-exempt corporations
• Financial institutions
• Foreign investment companies
• Small businesses
• Corporations currently going through bankruptcy