A personal holding company (PHC) is a closely held C corporation (C-corp) where at least 60% of its income is from passive investments like stocks, bonds, and rental activities. Most PHCs result from a business owner operating a business and selling all its assets but failing to distribute the money to the shareholders to avoid the shareholder dividend tax. Instead, the C-corp invests the money—and as a result, it has a lot of passive investment income that must be paid to the shareholder as dividends to avoid the 20% PHC tax.
Personal Holding Company Tests
To be classified as a PHC for tax purposes, a corporation must meet certain criteria laid out by the IRS. These criteria include the stock ownership test and the passive income test:
1. Ownership test: The ownership test is met if, during the last half of the tax year, five or fewer people own more than 50% of the value of the corporation’s stock. For the purposes of the ownership test, what the IRS considers to be an “individual” takes many shapes and forms.
Let’s look at which types of entities qualify as an individual:
- An employer-provided qualified pension, profit-sharing, or stock bonus plan
- Supplemental Unemployment Benefit Trust
- A private foundation that is funded by a single source
- A part of a trust permanently set aside or exclusively used in a charitable trust
2. Passive income test: The passive income test can be met if at least 60% of the PHC’s income is derived from investment income.
Personal Holding Company Income
The majority of PHCs are invested in relatively simple investments, and their PHC Income consists of dividends and interest. However, there are other more complicated investments that generate PHC Income, like rental property.
Patrick owns 100% of a corporation named Patrick Products, Inc., which used to manufacture and sell widgets. It sold all of its operating assets in the prior year and invested the proceeds in stocks and bonds rather than making a taxable dividend distribution to Patrick. After the sale, its only source of revenue is the interest and dividend income it receives from its investments.
The corporation does not engage in any active business activity. Plus, its income is derived exclusively from passive income.
Since the holding company has fewer than five shareholders (in this case, one) and more than 60% of the corporation’s income is derived from passive income, Patrick Products, Inc. is a PHC since it meets both the ownership test and the passive income test.
Personal Holding Company Tax
In addition to the 21% corporate income tax, a PHC’s undistributed personal holding company income (UPHCI) is subject to a tax of 20% for each tax year. Passive income sources, such as dividends, interest, rent, royalties, and annuities, are used to calculate the UPHCI.
The purposes of the PHC tax are to discourage individuals with high marginal tax rates from shielding their income from taxation and to encourage the PHC to distribute its earnings to shareholders.
Considering the same facts as in our sample above, in 2022, Patrick Products, Inc. earned $50,000 in dividends and $50,000 in interest income. The PHC made one distribution of $5,000 during the year and held $95,000. Since Patrick Products, Inc., did not distribute all of its PHC Income, it will be subject to the PHC tax.
Given, PHC tax = $95,000 (undistributed earnings) × 20% (tax) = $19,000.
This PHC tax is in addition to any corporate income tax Patrick Products, Inc. must pay. The PHC tax can be avoided by distributing an additional $95,000 to Patrick.
While we performed this function by hand, Patrick will compute this tax on Schedule PH.
Personal Holding Company Filing Requirements
A PHC must file IRS’s Schedule PH, U.S. Personal Holding Company (PHC) Tax, and attach it to IRS Form 1120, U.S. Corporation Income Tax Return. If you need help to complete it, check out our guide on how to fill out Form 1120.
Additionally, if the PHC thinks it will owe $500 or more in taxes when it files its return, then it must pay estimated taxes in quarterly installments using IRS Form 1120-W, Estimated Tax for Corporations. The estimated tax payments should be made on the 15th day of the fourth, sixth, ninth, and 12th months of the corporation’s tax year.
Let’s look at Patrick Products, Inc.’s Schedule PH, where Patrick figured the PH tax above.
In Part I of Schedule PH, Patrick Products, Inc. figured the total amount of their undistributed income, which was $95,000 ($100,000 – $5,000).
Sample Schedule PH Part I
In Part II, Patrick Products, Inc. figured the total amount of PHC Income, which is $100,000.
Sample Schedule PH Part II
Patrick Products, Inc. calculated its PHC tax using Part III. For 2022, the PHC tax is $19,000 ($95,000 × 20%).
Sample Schedule PH Part III
In Part IV, Patrick listed himself as the 100% owner of Patrick Products, Inc.’s common stock.
Sample Schedule PH Part IV
Parts V and VI of Schedule PH do not apply to Patrick, so they left each of these sections blank.
Sample Schedule PH Parts V & VI
How To Avoid the Personal Holding Company Tax
There are two general ways to avoid the PHC tax. The first is by reducing your undistributed PHC income by:
- Making distributions to the shareholder during the year
- Making distributions to the shareholder within 2.5 months after year-end and attaching an election under Sec. 563(b). These are referred to as throwback distributions and are limited to 20% of the amount of distributions made during the year.
- Giving charitable contributions which reduce income
- Investing in tax-exempt bonds which are excluded from taxable income
The second way is to avoid being classified as a PHC. You can do this by earning sufficient operating (non-PHC) income so that you don’t pass the 60% passive income test. Of course, restarting corporate operations isn’t an easy thing to do and may not be worth it.
Expert tip from Tim Yoder, CPA: Most PHCs simply project their annual PHC Income and then pay it out in dividends during the year. If there is a slight shortfall, then they make it up with a throwback dividend by March 15 of the following year. Any excess dividends from one year can be carried forward to the next year.
Frequently Asked Questions (FAQs)
A PHC must check Item A, box 2, of Form 1120, and then attach Schedule PH to the corporation’s tax return.
No, corporations may not claim a deduction for paying PHC tax.
The following entity types, even if ownership and passive income tests are met, are not PHCs:
- S corporations (S-corps)
- Tax-exempt corporations
- Banks, domestic building and loan associations, and certain lending or finance companies
- Life insurance and surety companies
- Certain small business investment companies operating under the Small Business Investment Act of 1958
- Corporations under the jurisdiction of the court in a Title 11 or similar case
- Foreign corporations
Bottom Line
If you’re selling the operating assets of your business, then consider the tax consequences of retaining the proceeds in your corporation, which will likely create a PHC, a C-corp that is both closely held and has a lot of investment income. There are hefty taxes imposed on any undistributed income, so you’ll need to track PHC Income constantly and ensure that you make adequate distributions to avoid the PHC tax.
