Personal Holding Company Tax Exposure in Corporate Structures

This week’s newsletter

The May 31, 2024 International Tax Lunch webcast covered foreign investors in U.S. real estate and specifically the use of corporate structures to hold the real estate assets.

Joshua Maya (Florida!), a frequent correspondent, asked a question about personal holding company tax exposure for rental income earned by a domestic C corporation as part of a foreign parent / domestic subsidiary holding structure and sent me a nice email with some analysis in it. Thanks, Joshua.

Since my coverage of the personal holding company tax topic in the webcast was brief and breezy, I figured I would write this up. Exposure (or not) to personal holding company tax is an important factor in selecting a holding structure for U.S. real estate.

Sample Scenario

Let’s assume a nonresident buys an apartment building in the United States. The building is owned by a domestic subsidiary of a foreign parent company – for estate tax protection.

Assume gross rental income for the year is $100,000. Heroically assume (to make the math easy) that there are zero deductible expenses.

Is there a personal holding company tax problem here? Is there any personal holding company income?

Rent is Personal Holding Company Income

The starting point is simple. Rent is personal holding company income.

Sometimes Rent is Not Personal Holding Company Income

Note the “except” which launches a two-pronged test.

• If you answer “yes” to both tests, rent is NOT personal holding company income. The exception applies.
• If you answer “no” to one or both tests, then rent remains personal holding company income because the exception fails
  

Law

Here’s the law.

Instructions for Schedule PH

Instructions for Schedule PH (Rev. December 2016) explains the two tests this way. (Find this at the specific instructions to line 18).

Rents can be excluded from PHC income if both of the following tests are met.

Test 1 Explained

Fraction

Test 1 asks you to make a fraction.

• The numerator is “adjusted income from rents” (defined at IRC Section 543(b)(3)).
• The denominator is “adjusted ordinary gross income” (defined at IRC Section 543(b)(2)).

Both of these definitions start with gross rental income and both allow identical (and selected) tax deductions.

Therefore, for a corporation with only rental income, the numerator will always equal the denominator. The income and deduction amounts are the same for both.

Application to the facts

In my simple facts, gross rental income is $100,000 and the deductions are zero. Therefore:

• “Adjusted income from rents” – the numerator – will be $100,000.
• “Adjusted ordinary gross income” – the denominator – will also be $100,000. (If the corporation had other types of income, the denominator would include those other income types, making the denominator larger).

Test 1 requires the fraction to yield a result of 50% or more. In my example, the fraction is 100%.

Test 1 is satisfied.

Test 2 Explained

In order to successfully exclude the rental income, we need to prove that the corporation passes Test 2 as well.

Law

Test 2 asks you to compute personal holding company income in a special way, and see how much of the personal holding company income was actually paid out as a dividend compared to what the Internal Revenue Code wants the corporation to pay out as a dividend.

Calculate dividends

Dividend history is totaled up at IRC Section 543(a)(2)(B)(i) - (iii). Park that number for a moment.

In my example, the corporation did not pay a dividend.

Calculate personal holding company income (excluding rental income)

Then compute the corporation’s personal holding company income EXCEPT for rent. That’s from the flushleft text at the bottom of IRC Section 543(a)(2)(B) (emphasis added):

Explained:

• “Computed without regard to this paragraph” refers to IRC Section 543(a)(2), which treats rental income as personal holding company income. So we ignore the rental income.
• “Computed without regard to . . . paragraph (6)” refers to IRC Section 543(a)(6) which treats rentals to 25%+ shareholders as automatically being personal holding company income.
• “Computed by including . . . copyright royalties” etc. – well, we don’t care about this stuff. 🙂

The Instructions for Schedule PH make it easier to understand. You calculate Personal Holding Company Income in Schedule PH, Part II, but exclude the amounts on Lines 18c and 22 of Schedule PH.

Since my example has only rental income earned by the corporation, personal holding company income is zero.

Park that “all the personal holding company income except rental income” number.

Calculate “ordinary gross income”

“Ordinary gross income” just means gross income minus capital gains and Section 1231 income. IRC Section 543(b)(1).

That’s $100,000 of rental income in my example. That’s the only income the corporation had.

Calculate 10% of “ordinary gross income”

This is required by the flush language of IRC Section 542(a)(2)(B) (emphasis added):

$10,000.

Personal holding company income minus 10% of ordinary gross income

Subtract the 10% amount ($10,000 in my example) from personal holding company income (zero in my example). You can’t go lower than zero, so zero is the answer. IRC Section 542(a)(2)(B), flushleft text (emphasis added):

Zero is the result of this subtraction.

Sum up dividends paid

Then sum up the dividends paid. This is required by IRC Section 542(a)(2)(B)(i) - (iii).

In my example, zero dividends were paid.

Over/under tells you if you satisfy Test 2

Finally! The moment of truth. You pass Test 2 if the sum of the dividends paid is greater than or equal to (personal holding company income minus 10% of adjusted gross income.

Find this in the flushleft text of IRC Section 542(a)(2)(B) (emphasis added):

Let’s do the math:

• Dividends paid = $0.
• Personal holding company income is greater than 10% of ordinary gross income by $0.
• Therefore, the sum of dividends paid (nothing) equals the excess of personal holding company income over 10% of ordinary gross income (nothing).

Test 2 is satisfied.

Conclusion: both tests satisfied, so exclude rental income from personal holding company income

We are trying to calculate the corporation’s personal holding company income. We now know that the $100,000 of rental income is eligible for the exception in IRC Section 543(a)(2). It is excluded from personal holding company income.

• $100,000 of rental income is theoretically personal holding company income; except that
• The entire amount is excluded from personal holding company income because the corporation satisfied both tests in IRC Section 543(a)(2).

Therefore, the corporation has zero personal holding company income.

And it’s impossible to have a personal holding company tax liability if the corporation does not have personal holding company income.

Implication

If a domestic corporation holds real estate and nothing but real estate, it will be safe from personal holding company tax on its rental income. That makes the corporate structure a little more appealing.

There is an important exception: rental to a 25% shareholder. I did not discuss this, but I would be careful in this scenario. See Internal Revenue Code Section 542(a)(6) for the rules.

Thanks!

Once again, thanks to Joshua for the nudge and the email with commentary on his experience with the personal holding company tax.