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The curious incident of the personal holding company in the night
Personal holding companies (PHCs) are an obscure relic of the Internal Revenue Code. Taxand USA explores why PHCs are so mysterious and incomprehensible by modern-day standards and serve as an example of a true trap for unwary taxpayers.
For a long time, individual income tax rates were substantially higher than corporate income tax rates, and since corporations are viewed as separate and distinct entities for US federal income tax purposes (and taxed accordingly), this disconformity in the tax rates resulted in what is essentially tax arbitrage, whereby taxpayers would use corporations as a tax-planning tool to minimise their tax liabilities.
Congress viewed this as unacceptable because, in its opinion, taxpayers were using corporations to improperly obtain a deferral of tax. It could have easily solved this problem by equalising the tax rates between individuals and corporations. Congress instead chose to enact two complicated mechanisms, the accumulated earnings tax (AET) and the PHC rules, which, while different in their application, had the same ultimate goal - to incentivise corporations to pay dividends to their shareholders on a current basis by penalising them for not doing so.
The AET is older than the PHC, having been enacted in its current form, more or less, in 1921, and is currently imposed at a rate of 20% on any corporation that is formed or availed of for the purpose of avoiding the income tax with respect to its shareholders by permitting earnings and profits to accumulate rather than be distributed. The PHC rules were enacted in 1934 in response to the continued perception that individual taxpayers were using corporations to improperly obtain a deferral of tax. The PHC rules impose a 20% tax on a PHC’s undistributed personal holding company income.
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If one looks at macroeconomic trends, corporate income tax rates may be reduced while individual income tax rates may stay the same or increase, leading to a situation not unlike 1934. These rules serve as nothing more than a trap for the unwary, and taxpayers need to be mindful of them when structuring their affairs so as not to inadvertently fall into them.