Ask Auburn

Dear Auburn, Theoretically, if a shareholder in a closely held corporation which derives over 60% of its income from residential rental revenues, is there any legal means which would allow avoidance of personal holding company tax?

Signed, Holding Me Backs

Dear Holding,

The question you’ve posed has a very simple three-option answer. But before I conclude, a little explanation: 

A corporation may be subject to personal holding company (“PHC”) tax pursuant to IRC § 541 if the company derives at least 60% of its income from investments like stocks, notes, royalties and real estate, and more than 50% of the stock is owned, directly or indirectly, by five or fewer persons at any time during the last half of the tax year. 

S Corporations Cannot be Personal Holding Corporations

The PHC rules are aimed at corporations established to hold investments of the shareholders. In addition to the regular corporate taxes, a tax of 39.6% is imposed on the undistributed PHC income, aka “retained earnings”. Note that this only applies to undistributed income. If you distribute all your income, you don’t have an issue. Therefore, since an S corporation distributes its income to the shareholders each year, it cannot have PHC income. 

Rental Income is an Exception

Where rental income is over 50% of the corporation’s income, it is not counted towards personal holding corporation income. This makes sense because of companies like a local video or furniture rental store, which derive all of their income from rental activities. Also, remember these rents are from property owned by the corporation, not management fees it may collect from rental properties owned in other entities. 

But Beware Depreciation

In determining whether 50% of the corporation’s income is from rents, rents must be reduced by deductions for depreciation, amortization, taxes and interest. The word “Must” in the sentence above should be a clue that this provision is a double edged sword. In one instance, if your corporation has active business, the requirement that rents are reduced could keep your corporation’s income from being holding company income. On the other side of the sword, if your company has other passive investments, this may keep your company from attaining the 50% level that would remove all rental income from the personal holding corporation status.

The solution: either 1) don’t retain earnings, 2) make an S election or 3) keep income from other passive investments far away from your rental corporation.

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