Personal Holding Company

A personal holding company is a corporation formed by 1 to 5 taxpayers to hold highly appreciated property or investments so that both voting and nonvoting stock can be issued by the corporation where the shareholders intend to gift the nonvoting shares to reduce their estate, while keeping the voting shares to maintain control over the company. The appreciated property or investments can be transferred to the corporation in exchange for its stock in a tax-free transaction, in the same way that the purchase of shares from a company by individual investors is a tax-free event. The personal holding company can also be useful to hold assets are not easily divisible, such as a business, real estate, art, or valuable antiques.

If a corporation qualifies as a personal holding company under IRC §541, then additional taxes will be assessed on the income of the corporation. Not only is all income tax to the highest individual income tax rate, but is also subject to the corporate tax on undistributed income of personal holding companies, equal to 20% of undistributed income for the tax year, as of the Taxpayer Relief Act of 2012.

The tax code list 2 tests to determine if a corporation is a personal holding company: an income test and a stock ownership test. The income test satisfied if at least 60% of the corporation’s ordinary adjusted gross income is personal holding company income, which includes dividends, interest, rents, certain royalties, or income earned for certain types of personal services. The stock ownership test requires that more than 50% of the value of the outstanding stock is owned directly or indirectly by 5 or fewer individuals at any time within the last 6 months of the taxable year. A lack of business purpose for the corporation indicates a personal holding company. Additionally, when assets are sold by the corporation, or upon liquidation thereof, then the gain will be taxed at the corporate level and at the shareholder level.

Even if the company does satisfy the 2 tests defining a personal holding company under the tax code, it may be classified as such by the IRS if there is no business purpose for the corporation and the formalities of operating the business are not followed.

If the personal holding company can avoid being characterized as such under the tax code, then significant wealth can be transferred without it being subject to gift or estate taxes, or at a reduced tax liability, especially if the nonvoting shares can be distributed over time, to allow the use of the gift tax annual exclusion. Moreover, courts have allowed discounts of 10 to 55% of the shares, since the marketability of the shares are presumably impaired because it is a closely held corporation. For instance, if the personal holding company held 10,000 shares of Facebook, then the value of the stock will not be worth the 10,000 shares, because the shares cannot be readily sold. Most discounts allowed by the courts range from 20 to 40%. However, some courts have not allowed a discount, especially when the personal holding company held either only cash or marketable securities, without significant liabilities.

If the shareholder provides bona fide services for the corporation and is paid a salary, then it will be taxed at the highest rate, currently 37% on compensation, but it can be fully deducted by the corporation. If the compensation is deemed to be unreasonable, then the excess will be taxed additionally at the corporate level.

When deciding on forming a personal holding company, consideration should be given to the cost of forming the corporation, how it will be dissolved, and state and local franchise taxes.

Employee shareholders could also benefit from corporate fringe benefits, some of which have tax advantages, such as health insurance, which will not be subject to marginal or FICA taxes.

Additionally, life insurance policies can be transferred to the corporation or the corporation can buy life insurance policies on its owners. Only a percentage of the proceeds of the policies will be subject to estate tax in proportion to the percentage owned by the decedent at the time of death. Also, due to the ownership of the stock, the decedent's executor will control the personal holding company’s voting common stock, so the executor can direct the corporation to make a §303 stock redemption to pay estate taxes and expenses.

If the personal holding company is owned by one or both spouses in a community property state, then the entire corporate stock will receive a stepped-up basis when 1 of the spouses dies.

IRC §542(c) list 10 types of business entities specifically excluded from the personal holding company status, including tax-exempt corporations, life insurance companies, banks, surety companies, and foreign corporations.

IRC §542(a)(1) defines adjusted ordinary gross income as gross income minus gains from the sale of capital assets and IRC §1231 property minus depreciation, interest, certain taxes, and certain rents and royalties [IRC §543(b)].