Personal Holding Company Tax

When comparing the limited liability company (LLC) and the corporation, you'll need to be aware of special tax implications that specifically affect regular corporations, but not LLCs. One of these considerations is the possibility of liability for personal holding company tax.

The personal holding company rules penalize closely held corporations for earnings that remain undistributed to shareholders. The rules are designed to prevent corporations from acting as incorporated pocketbooks of shareholders, collecting investment income or salaries on behalf of shareholders in order to avoid taxation at otherwise applicable individual income taxes.

A personal holding company is generally a corporation that meets the following tests:

• The corporation is a "regular" corporation—the tax does not apply to S corporations.
• Five or fewer individuals own more than 50 percent in value of the corporation's outstanding stock at any time during the last half of the tax year.
• 60 percent or more of the corporation's adjusted ordinary income is personal holding company income.
.

Personal holding company income consists of dividends, interest and certain royalties. The personal holding company tax is imposed not on all personal holding company income, but on undistributed personal holding company income. Thus, if all of the corporation's dividend income is distributed to the shareholders, there will not be a risk of personal holding tax liability. And, remember, the tax never applies to an S corporation because the income is always passed through to the shareholders.

The tax is extremely complicated due to its many exceptions. In practice, the tax will not usually apply to small business owners. While the typical small business may be owned by five or fewer individuals, in most cases its income will not be passive, or will fall within some of the exceptions.

However, in an arrangement where a holding company and an operating company are used, the tax may very well apply to the holding company unless a consolidated tax return is filed. That consolidated return opens its own set of complications and complexities.

This tax can be avoided by making a subchapter S election, since S corporations are not subject to the tax. Once again, however, with an LLC you don't have to worry about dealing with this tax, or avoiding it.