What Is the Personal Holding Company Tax and How Does It Work?

The personal holding company (PHC) tax is imposed by the IRS to prevent closely held corporations from avoiding dividend taxation. It targets companies that generate most of their income from passive sources like interest, dividends, and rent while being owned by a small group of individuals. The goal is to ensure these corporations distribute earnings rather than retain them to defer shareholder taxes.

Ownership Structure Criteria

A corporation qualifies as a PHC if more than 50% of its stock is owned by five or fewer individuals at any point during the last half of the tax year. This ownership test, outlined in Section 542(a)(2) of the Internal Revenue Code, applies regardless of whether the shareholders are related or acting together. The IRS enforces constructive ownership rules under Section 544, attributing stock ownership from trusts, partnerships, and family members to prevent circumvention.

Stock ownership includes both direct and indirect holdings. For example, if a shareholder owns 30% of a corporation directly and another 25% through a family trust, their total ownership is 55%, making the company subject to PHC classification if other conditions are met. Attribution rules extend to spouses, children, grandchildren, and parents, meaning a corporation owned by multiple family members may still qualify even if no single individual holds a majority stake.

Both voting and non-voting shares count toward the ownership percentage, preventing companies from issuing non-voting stock to avoid PHC status. Additionally, stock options and convertible securities may be treated as exercised when determining ownership percentages.

Income Classification Requirements

A corporation meets the income test for PHC status if at least 60% of its adjusted ordinary gross income (AOGI) for the tax year consists of personal holding company income (PHCI). Defined under Section 543 of the Internal Revenue Code, PHCI includes passive income sources such as dividends, interest, royalties, and certain types of rent.

Rental income classification depends on the corporation’s level of involvement. If a company actively manages rental properties by providing significant services beyond basic maintenance, the income may not be considered PHCI. However, if rental revenue comes from leasing real estate with minimal involvement, it generally qualifies. Similarly, royalties from patents, copyrights, or trademarks count as PHCI unless they stem from a corporation’s primary business operations.

Interest income is a common component of PHCI. Earnings from loans to third parties, bonds, or other debt instruments typically qualify unless they are tied to the corporation’s active trade or business. For example, a financing company that lends to customers as part of its primary operations would not include this revenue in PHCI calculations, but a real estate holding company earning interest from tenant deposits would.

Dividends received from other corporations are also considered PHCI, but exceptions exist. If a corporation owns at least 50% of another company’s voting stock and receives dividends from it, this income is excluded from PHCI calculations. However, dividends from passive investments, such as publicly traded stocks, are fully included.

Calculating the Tax Liability

Once a corporation qualifies as a PHC, it is subject to an additional tax on its undistributed personal holding company income (UPHCI). Imposed under Section 541 of the Internal Revenue Code, this tax is a flat 20% rate and applies only to retained earnings.

To determine UPHCI, a corporation starts with taxable income and makes several adjustments. Deductions such as federal income taxes and net operating losses are subtracted. Additionally, expenses related to producing PHCI, like interest paid on loans used to acquire passive investments, are removed. The result is the corporation’s adjusted taxable income, from which the dividends-paid deduction is subtracted to arrive at UPHCI.

The dividends-paid deduction is key to reducing or eliminating PHC tax liability. Any qualifying distributions made to shareholders before the end of the tax year, or within 2.5 months after year-end under the consent dividend election, lower the taxable base. Corporations anticipating PHC status often plan distributions strategically to minimize exposure. If a company fails to distribute enough earnings, it must pay the 20% tax on the remaining UPHCI, reported on Schedule PH of Form 1120.

Distribution Obligations

Corporations subject to the PHC tax must manage dividend distributions carefully to minimize liability. The IRS allows a dividends-paid deduction, reducing the amount of UPHCI subject to the 20% tax. To qualify, distributions must be made within the tax year or, under Section 563 of the Internal Revenue Code, within 2.5 months after year-end as a consent dividend. Consent dividends are hypothetical distributions where shareholders agree to treat retained earnings as if they had been paid out.

Timing and form of distribution are important. Regular dividends declared and paid before the fiscal year-end automatically count toward the deduction, but deficiency dividends—those declared after an IRS determination of PHC status—require a special election under Section 547. Deficiency dividends must be paid within 90 days of the IRS notice and reported on Form 976 to avoid penalties.

Exemptions from PHC Status

Not all corporations that meet the ownership and income tests are subject to the PHC tax. The Internal Revenue Code provides exemptions based on industry, operational structure, or the nature of income. These exemptions ensure the tax applies only to companies improperly accumulating passive income rather than those engaged in legitimate business activities.

Certain corporations are explicitly excluded under Section 542(c). Banks, insurance companies, and finance firms are exempt because their primary business involves earning interest and dividends as part of normal operations. Personal service corporations, such as law firms and medical practices, may avoid PHC classification if their income comes primarily from active services rather than passive investments. Additionally, corporations that qualify as regulated investment companies (RICs) or real estate investment trusts (REITs) are exempt, as they are already subject to strict distribution requirements.

Another exemption applies to corporations that can demonstrate their income is not being retained to avoid shareholder taxation. If a company can prove that its earnings are needed for business needs—such as expansion, debt repayment, or capital improvements—it may avoid PHC status even if it meets the ownership and income tests. The IRS evaluates this on a case-by-case basis, requiring documentation to justify retained earnings.

Penalties for Noncompliance

Failing to comply with PHC tax regulations can lead to financial consequences. The IRS imposes penalties for failing to pay the 20% tax on UPHCI and for errors in classification, reporting, and distribution calculations.

One immediate consequence is the assessment of back taxes, interest, and penalties if the IRS determines a corporation miscalculated or failed to pay the PHC tax. If a company underreports its UPHCI, it may be subject to accuracy-related penalties under Section 6662, adding an additional 20% to the unpaid tax. In cases of willful neglect or fraud, penalties can escalate significantly, with potential civil and criminal repercussions. Additionally, corporations that fail to distribute sufficient earnings may face ongoing PHC tax liabilities in subsequent years.