Since the Tax Cuts and Jobs Act reduced the top federal corporate income tax rate to 21%, an increasing number of business owners are contemplating establishing their businesses as C corporations or switching their pass-through entities to C corporation status. Previously, corporate income was taxed at graduated rates ranging from 15% to 35%.
Entity choice is a complex decision that involves consideration of several financial, tax and legal factors. One factor that shouldn’t be overlooked is a closely held C corporation’s potential liability for the personal holding company (PHC) tax.
A 21% tax rate is attractive, especially when you consider that owners of pass-through entities — partnerships, S corporations and LLCs — are currently taxed on their shares of business income at individual rates as high as 37%. But for a true apples-to-apples comparison, take into account pass-through owners’ effective tax rates (which may be substantially lower than 37%) as well as the potential impact of double taxation.
A C corporation’s income is subject to two levels of tax: 1) at the corporate level at the 21% rate, and 2) at the individual shareholder level when that income is distributed. Qualified dividends are currently taxed at rates up to 20%.
One way to avoid, or at least defer, double taxation, is to hold earnings in the corporation rather than distribute them to shareholders as dividends. But if a corporation is considered a PHC, doing so can trigger the PHC tax. Even if a corporation isn’t a PHC, retaining earnings can result in accumulated earnings taxes (AET). (See “Is your corporation subject to AET?” below.)
The PHC tax was originally created to prevent individuals from using C corporations to shelter passive income. But despite its name, the tax isn’t limited to corporations that hold only passive investments. Even active businesses can be ensnared by the tax if they meet the requirements.
A PHC is a C corporation that meets two tests:
1. Ownership. At any time during the last half of the tax year, more than 50% of the value of its outstanding stock is held, directly or indirectly, by or for five or fewer individuals.
2. Income. At least 60% of its adjusted ordinary gross income (AOGI) for the tax year is PHC income — that is, dividends, interest, rents, certain royalties, income from certain personal service contracts and other primarily passive income.
Some corporations are excluded from the definition of PHC, including tax-exempt entities, banks, life insurance companies and foreign corporations.
If a corporation is a PHC, the tax applies at a flat 20% rate — in addition to regular corporate income tax — to its undistributed PHC income. Note that PHC income for purposes of the income test and undistributed PHC income are two different concepts. The latter calculation starts with the corporation’s taxable income. Then adjustments are made for certain taxes paid, charitable contributions, net capital gains, dividends paid and other items.
If your corporation meets the definition of a PHC in a given year, you can use several possible strategies to avoid the tax. One option is to increase the number of shareholders. For example, if you give or sell stock to others, it may be possible to reduce the holdings of the top five shareholders to less than 50%. Keep in mind, however, that the “constructive ownership” rules treat stock owned by certain related individuals or entities as owned by you.
Another strategy is to boost ordinary income — for example, by accelerating business income from next year into this year — so that PHC income drops below 60% of AOGI. Likewise, you could defer PHC income to next year or reduce investments that generate PHC income.
Finally, you could reduce or eliminate undistributed PHC income by paying dividends to shareholders. Of course, this option triggers double taxation. But that’s usually preferable to paying the PHC tax, which can result in triple taxation when PHC income is ultimately distributed.
Monitor your PHC status
The applicability of the PHC tax is reassessed annually. So, it’s a good idea to monitor your corporation’s ownership, income mix and accumulated earnings to determine your liability. Even if you’ve never been subject to the tax before, an economic recession or other events can cause your business income to decline in relation to investment or other passive income. If this happens, it can increase your potential exposure to the dreaded PHC tax.
Is your corporation subject to AET?
Even if your corporation isn’t a personal holding company (PHC), be aware of the accumulated earnings tax (AET). Similar to the PHC tax, the AET is a flat 20% additional tax on undistributed taxable income. The AET can apply to any C corporation, but, unlike the PHC tax, it doesn’t apply automatically. The IRS may assess the tax, upon audit, if it finds that the corporation has accumulated an unreasonable amount of earnings with the intent of avoiding income tax.
Generally, the first $250,000 in accumulated earnings ($150,000 for certain personal service corporations) is exempt from the AET. But accumulated earnings above that threshold may be subject to the AET.
To avoid the tax, consider distributing some earnings to shareholders to bring your accumulated earnings below the threshold. Otherwise, be prepared to convince the IRS (or a court) that your accumulated earnings are reasonable in light of your business needs.
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