Understanding the problems of PHC status: a failure to avoid personal holding company status can cost shareholders dearly in additional taxes.

• Author: Ellentuck, Albert B.

Tax problems and administrative difficulties can arise if a corporation is classified as a personal holding company (PHC). Avoiding PHC status is important because:

* The income will be taxed at the regular corporate rate when it is earned by the corporation.

* If the income is not distributed and the corporation is subject to the PHC tax, a 20% tax will be imposed on the undistributed personal holding company income (Sec. 541).

* When the income is finally distributed to the shareholder (e.g., as a dividend), it will be taxed at the shareholder level. Even if it is distributed to the shareholder in the form of a deductible expense (e.g., compensation) after the PHC tax has been paid, it will be subject to double-taxation, i.e., the corporation paid the PHC tax on the income, and the shareholder pays tax on it when it is received.

The purpose of the PHC tax is to prevent corporations from accumulating their earnings instead of distributing those earnings as taxable dividends. Qualified corporate dividends are taxed to noncorporate shareholders at a maximum rate of 20%. These dividends, if not qualified, otherwise would be taxed at a 39.6% rate (for 2016, gain recognized by single filers with taxable income above $415,050, married couples filing jointly with taxable income above $466,950, heads of household with taxable income above $441,000, and married taxpayers filing separate returns with taxable income above $233,475). A 15% tax rate applies to qualified dividends that otherwise would be taxed at a 25%, 28%, 33%, or 35% rate; and a 0% tax rate applies to qualified dividends that otherwise would be taxed at a 10% or 15% rate.

Although the maximum tax rate on qualified dividends is 20% (Secs. 531 and 541), it could be worse because the accumulated earnings tax (AET) and PHC tax rates do not reflect the 3.8% net investment income tax imposed on higher-income individuals. This can result in a maximum 23.8% tax rate on qualified dividends. On the other hand, dividends paid to shareholders may be taxed at a lower 15% or 0% rate.

Adjusting AMT for Circulation Expenses

The alternative minimum tax (AMT) adjustment for circulation expenses does not apply to any corporations other than PHCs. For purposes of the AMT, a PHC must capitalize circulation expenses that are fully deductible for regular tax purposes (Sec. 56(b)(2) (C)).The amount capitalized is amortized ratably over three years.

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