2015-Issue 15— Everyone loves good surprises. Examples of good surprises include the following (not an all-encompassing list): surprise puppies, surprise gold, surprise unicorns, etc.
However, the same cannot be said for bad surprises. No one likes bad surprises. And do you know what an example of a truly bad surprise is? Personal holding companies (PHCs). PHCs are an obscure relic of the Internal Revenue Code, an artifact from a time long ago when the perpetual war between Congress and taxpayers seeking to minimize their tax liabilities by any means necessary was embryonic in nature. Like Christopher Nolan’s Inception (or Interstellar, for that matter), PHCs are so mysterious and incomprehensible by modern-day standards that they serve as an exemplar of a true trap for the unwary; arguably most, if not all, taxpayers subject to these rules do not realize they have been ensnared by them until it’s too late.
This edition of Tax Advisor Weekly explores the Kafkaesque nature of PHCs and recounts the story of how an antiquated law that was enacted to curtail certain long-abandoned tax avoidance transactions is, more than eighty years later, still wreaking havoc on the lives of modern-day taxpayers.
Fighting the Incorporated Pocketbook with Chaos
Believe it or not, corporations were the original tax shelter. This statement may sound insane, but it’s true. 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 U.S. 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 minimize their tax liabilities.
Most often, this manifested itself in the form of taxpayers contributing assets (e.g., stocks, bonds, real estate, etc.) to corporations that generated various types of passive income, such as interest, dividends, capital gains, rents, royalties, etc. Again, this sounds insane by modern-day standards, because in today’s world any tax advisor worth his salt will tell you that placing assets, appreciated or otherwise, that generate passive income into a corporation is almost never a good idea, specifically because any income or gains realized will be subject to two levels of taxation. As Bittker and Eustice so eloquently put it, “a corporation is like a lobster pot: easy to enter, difficult to live in, and painful to get out of.”
But back in 1934, when the PHC rules were enacted, this is exactly what taxpayers were doing, specifically because the income and gains realized from the contributed assets were taxed at a substantially reduced rate, allowing the income to compound more quickly inside the corporation and greatly increasing the rate of return on such assets. Individual taxpayers were then able to delay the day of reckoning because they would be taxed on the income that had built up inside the corporations only when such corporations either liquidated or paid a dividend, or when they sold their stock, the timing of any of which was very much under the control of such shareholders.
Congress viewed this result 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 equalizing the tax rates between individuals and corporations (which it did eventually, sort of, although it took almost a century). But, never being one to take the easy walking trail when the arduous, rockslide-prone mountain pass would just as well suffice, 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 incentivize corporations to pay dividends to their shareholders on a current basis by penalizing them for not doing so. The AET and the PHC rules are discussed further below.
The Accumulated Earnings Tax — Is That All There Is?
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 percent 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.
As an aside, the statute references the accumulation of “earnings and profits,” but that term is not defined in either the Internal Revenue Code or the regulations that have been issued by the Treasury Department. Over the years, case law has defined the term to describe a corporation’s economic wherewithal to pay a dividend to its shareholders without returning its invested capital to them.
So if a corporation 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, it’s subject to the AET. If the foregoing sounds somewhat flimsy, well, that’s because it might very well be. Unfortunately, the Internal Revenue Code does not provide much guidance on what constitutes a corporation being formed or availed of for the purpose of “avoiding the income tax with respect to its shareholders,” merely stating in a somewhat oblique fashion that this occurs when the earnings and profits of a corporation are permitted to accumulate beyond the “reasonable” needs of the business, whatever that means (although it should be noted that Congress has generously allowed for most corporate taxpayers to claim a minimum reasonable need of $250,000).
Indeed, there is a substantial body of case law that has developed as a result of taxpayers and the IRS arguing over whether and to what extent corporate earnings and profits are required to be accumulated for the reasonable needs of the business. While a detailed discussion of the AET is outside the scope of the article, a few key points should be made: (i) it applies to both publicly traded and private companies; (ii) whether the AET applies to a corporation or not is highly subjective and turns on intensely factual analyses; and (iii) it’s asymmetrical in that it may only be asserted by the IRS upon audit (i.e., taxpayers cannot self-assess the AET, not that they would want to). In the event the AET applies, although you must go through a specific calculation, the end result is that the corporation pays a 20 percent tax on the income that it theoretically should have distributed as a dividend, which is the same amount of income tax that the shareholders would have incurred had the corporation actually paid the theoretical dividend.
Note that the application of the AET essentially results in three levels of taxation, since the corporation is paying both the corporate income tax and the income tax that the shareholders would have incurred had it actually paid a dividend, and then the shareholders are taxed either when the corporation liquidates or pays a dividend, or when they sell their stock. Had the corporation actually paid a dividend, the income would have only been subject to two levels of taxation, hence the incentive to actually pay a dividend in the first place and dispense with all of this unpleasantness.
Congress has provided some fairly generous rules that give corporations the ability to pay dividends after the end of their tax years in order to avoid the AET or PHC rules, even allowing so-called “consent dividends,” whereby the corporation is deemed to pay a dividend to its shareholders, who are then deemed to contribute the dividend back to the corporation in the form of a capital contribution, but no actual cash changes hands.
Nobody Expects the Personal Holding Company!
As noted above, 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 percent tax on a PHC’s undistributed personal holding company income, and are similar to the AET in that they also result in three levels of taxation. Unlike the AET, which as described above is imposed only if certain subjective criteria are satisfied, the PHC rules are strictly objective in nature; if a corporation is classified as a PHC, then it’s subject to a 20 percent tax on its undistributed personal holding company income regardless of the subjective intent of the owners to operate the business in corporate solution. In addition, taxpayers are required to self-assess the 20 percent tax on undistributed personal holding company income. One final point: to the extent a corporation is classified as a PHC, it is exempt from the AET because the PHC rules should, theoretically, reach the same result that the AET would if it were to apply (i.e., the corporation is taxed on the income it should have paid to its shareholders as a dividend).
For a corporation to be classified as a PHC, it must satisfy the following requirements:
(i) Ownership test: At any time during the last half of the taxable year, more than 50 percent in value of its outstanding stock must be owned, directly or indirectly, by five or fewer individuals or certain trusts; and
(ii) Income test: At least 60 percent of its income (as calculated under the statute) must consist of personal holding company income, which generally consists of the following (not an all-inclusive list): dividends, interest, certain royalties, annuities, rents and personal service contracts.
Certain corporations are exempt from the PHC rules, including banks, life insurance companies, surety companies, foreign corporations, tax-exempt corporations and corporations engaged in the business of lending or financing (among others). Also note that in the context of consolidated groups, the PHC rules are generally applied on a company-by-company basis, and only in certain limited circumstances are they applied on a consolidated basis.
Although foreign corporations are exempt from the PHC rules, foreign shareholders are not. Therefore, a domestic corporation with five or fewer individual shareholders that are not U.S. citizens or residents for U.S. federal income tax purposes would appear to satisfy the ownership test described above. This can have far-reaching and non-obvious implications, such as if the corporation at issue makes a consent dividend to its shareholders (as described above), which includes non-U.S. residents. Assuming such foreign shareholders are residents of a country that has not entered into a tax treaty with the United States, a 30 percent withholding tax may be due on the consent dividend, which would be payable by the corporation, notwithstanding the fact that cash was not actually paid to the shareholders.
With respect to the ownership test, the PHC framework contains a mind-bogglingly expansive attribution rule that is used in determining whether the shareholders indirectly own stock in the corporation at issue. This attribution rule is almost all-encompassing, even more so that the attribution rules that are used in other parts of the Internal Revenue Code. In particular, in the case where a partnership owns all of the stock of the corporation at issue, the attribution rule not only provides that all partners own their ratable share of the underlying stock, but that they own all of the other stock that their partners own.
So, as an example, assume that a partnership with one hundred individual partners, each of whom owns 1 percent of the partnership, owns all the stock of a corporation that otherwise satisfies the income test. Under the attribution rule, all partners not only directly own 1 percent of the corporation that corresponds with their ownership in the partnership, but in addition they are viewed as owning the other 99 percent of the corporation that the other partners own. So each partner is deemed to own all of the stock of the corporation, obviously satisfying the ownership test many times over. While this sounds like a ridiculous result, that is how the statute operates.
This would be especially problematic for private equity, which frequently invests through partnership structures. Absent any mitigating circumstances, corporations that otherwise satisfied the income test might have difficulty receiving private equity funding, for fear that they would be classified as PHCs due to the attribution rule discussed above. However, the IRS has provided some surprising relief on this issue as discussed below.
The IRS Dons Its White Armor?
Private Letter Ruling 201208025 discusses a publicly traded company that owned certain subsidiaries that otherwise satisfied the income test when viewed on a separate company basis. The publicly traded company appears to have been owned by several private equity funds, and it sought a ruling from the IRS that the attribution rule discussed above would not cause the ownership test to be satisfied. The IRS granted such a ruling, notwithstanding the fact that a literal reading of the attribution rule might yield the conclusion that the application of it would cause the ownership test to be satisfied. Although the ruling is somewhat conclusory in nature, the IRS appears to have taken a rather relaxed view of the application of the attribution rule. This is a very taxpayer-friendly ruling, and should reduce the risk that an investment by a private equity fund would cause the ownership test to be satisfied.
Alvarez & Marsal Taxand Says:
The convoluted premise of the PHC rules and their utter inapplicability to modern-day transactions are irrational to the point that Roose Bolton would probably appreciate them, and King Aerys II Targaryen too, if he were able. However, 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 to not inadvertently fall into them.
About the Author
Senior Director, San Francisco
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Simon Bernstein, Senior Associate, and Sean Wilson, Associate, contributed to this article.
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