Understand the Personal Holding Company Tax Framework Before You Act
The personal holding company tax is an additional federal tax regime imposed under the Internal Revenue Code on certain closely held corporations with substantial passive-type income. In broad terms, a corporation is a personal holding company if, during the last half of the taxable year, more than 50 percent of the value of its stock is owned, directly or indirectly, by five or fewer individuals, and at least 60 percent of its adjusted ordinary gross income consists of personal holding company income. If the tests are met, a 20 percent tax applies to the corporation’s undistributed personal holding company income. This is not a mere formality; it is a punitive regime designed to discourage the sheltering of investment income inside a corporation.
In practice, what constitutes personal holding company income is broader than many owners expect. It generally includes dividends, interest, annuities, certain rents and royalties, and income from personal service contracts, among other categories. The definition contains intricate exceptions, limitations, and look-through rules that turn seemingly straightforward revenue streams into a compliance puzzle. The fact pattern is rarely “simple,” and reasonable-seeming arrangements can inadvertently satisfy the PHC tests. Before you implement any planning, it is essential to understand that the PHC regime is a separate overlay from the regular corporate income tax and the accumulated earnings tax, and each has its own definitions, calculations, and timing rules that must be modeled carefully.
Diagnose Whether Your Corporation Is at Risk—The Two Core Tests
Effective planning starts with a rigorous diagnostic of whether you are within reach of the PHC regime. There are two gates. First is the stock ownership test: during the last half of the taxable year, more than 50 percent (by value) of the corporation’s stock is owned, directly or indirectly, by five or fewer individuals. The constructive ownership rules are unforgiving: stock owned by certain entities may be attributed to their owners, family members may be aggregated, and options can be deemed ownership. Second is the income test: at least 60 percent of the corporation’s adjusted ordinary gross income (AOGI) consists of PHC income categories. Both conditions must be satisfied for PHC status.
Two common misconceptions cause expensive surprises. First, many owners believe that if the corporation is “active,” it cannot be a personal holding company. That is incorrect; an otherwise operating business can meet the PHC definition if its income mix tilts toward passive categories. Second, some assume that taxable income levels drive the analysis. They do not. The 60 percent test keys off AOGI, a specialized calculation that starts with gross income and makes specific adjustments unrelated to taxable income, deductions, or net losses. A corporation with a loss can still be a PHC. Running the calculations quarterly, not merely at year-end, is prudent because the stock ownership test takes a snapshot during the final six months, and ownership changes or option grants late in the year can unexpectedly tip the balance.
Rebalance the Income Mix Toward Active Income—Legitimately and Documented
Because the 60 percent threshold looks to the proportion of PHC income within AOGI, a powerful planning lever is the generation and documentation of active business income. This is not a matter of renaming revenue. The IRS will recharacterize arrangements that lack substance. The objective is to create and substantiate bona fide operating revenue that is not categorized as PHC income. For example, expanding service offerings performed by employees, selling products at arm’s length, or charging market-based fees for demonstrable management, logistics, or technology services can alter the income mix when done with appropriate staffing, contracts, and transfer pricing support.
Several missteps are common. Payments labeled as “management fees” that in substance are distributions of profits will be challenged and may be recast as dividends, returning you to PHC territory. Likewise, “interest” earned from related-party notes often counts as PHC income; substituting equity with dividend look-through relief may be more effective, as discussed below. A disciplined approach includes: written service contracts that allocate risks and responsibilities; time sheets and cost accounting to evidence real activity; pricing supported by comparables; and careful tracking so that your general ledger can withstand a PHC audit. It is not enough to be busy; you must be able to show that the corporation’s income is actively produced rather than passively received.
Use Subsidiaries and Look-Through Rules to Neutralize Passive Income at the Holding Company
Closely held groups often accumulate operating businesses within a parent holding company. If the parent simply collects dividends from subsidiaries, those dividends are typically PHC income. However, the Code contains a crucial look-through exception: dividends from a corporation that is more than 50 percent owned may be excluded from PHC income to the extent they are attributable to the payor’s non-PHC income. In plain terms, if your subsidiary earns active, non-PHC income, a properly structured dividend up to the amount of that active income can flow to the parent without increasing the parent’s PHC fraction. The subsidiary’s books and records must enable a tracing of dividend sources to its income categories.
Implementation requires care. Ownership percentage, timing of dividends, and the subsidiary’s own PHC status are all relevant. If multiple tiers exist, each tier must be analyzed. Funding the parent through interest-bearing intercompany loans or passive royalties instead of dividends usually backfires, because intercompany interest and certain royalties are themselves PHC income at the parent. A well-designed structure may include: ensuring the parent has more than 50 percent ownership of key subsidiaries; using dividends rather than related-party interest; evidencing the subsidiary’s non-PHC income with schedules; and aligning dividend timing so the look-through exclusion is maximized during the parent’s taxable year. Documentation is decisive; without it, the exclusion is often denied on examination.
Classify Rents, Royalties, and Service Revenue Correctly—Do Not Rely on Labels
Rents, royalties, and service revenues sit at the center of many PHC disputes. As a baseline, rents are generally PHC income. However, there is an important exception if rents constitute at least 50 percent of AOGI. In that case, rents may be excluded from PHC income, subject to specific limitations. Achieving the exclusion is not as simple as assigning assets to a “rental” subsidiary; you must demonstrate real rental operations, bear meaningful landlord risks, and avoid adjacent income streams that are still PHC (such as interest on tenant deposits). The mix of services provided with the rental also matters: services that are necessary to the rental usually do not taint the exception, whereas services that are more akin to a separate business may change the analysis.
Royalties present similarly nuanced issues. Copyright royalties may be treated differently from mineral royalties; certain technology and software licensing income may be excluded in limited circumstances when tied to active development by the corporation. For service revenue, the personal service contract rule can be a trap: if amounts are received under a contract for services to be performed by an individual who owns a significant interest in the corporation, those amounts can constitute PHC income even if the corporation employs staff. Careful contract drafting, staffing models that do not make the shareholder indispensable, and documentation of work performed by non-owner employees are critical to avoid reclassification. When in doubt, seek preemptive review; retroactive fixes rarely succeed.
Choose Capital Structure and Financing Instruments With PHC in Mind
Interest is quintessential PHC income. A closely held corporation that accumulates cash and extends loans to affiliates, owners, or portfolio companies may be manufacturing PHC income inadvertently. Before issuing a note, consider whether equity capital is more appropriate. Dividends from sufficiently owned subsidiaries may benefit from the look-through exception, while interest does not. If debt is commercially necessary, examine whether the borrower’s profile, collateral, and rate produce an arm’s-length lending business; otherwise, your “lending” activity is likely to be seen as passive, not active.
Other financing features require scrutiny. Detachable warrants or conversion rights held by investors can influence the stock ownership test through constructive ownership of options. Preferred stock that behaves like debt may lead to dividend streams that are not excludable. Cash management programs that sweep excess funds into interest-bearing instruments will increase PHC income; alternatives include funding operating expansion, acquiring active businesses, or holding short-duration non-interest-producing assets when appropriate. Finally, remember that tax-exempt interest can still be PHC income for purposes of the 60 percent test; “tax-exempt” does not mean “PHC-exempt.”
Manage the Shareholder Base and Attribution Rules Proactively
Beating the 60 percent income test is only half the battle. A corporation with broadly dispersed ownership is not a PHC even if it has passive income. However, the stock ownership test’s constructive ownership rules are highly complex. Family attribution can aggregate ownership across spouses, children, parents, and sometimes further relatives. Ownership through partnerships, trusts, and corporations is often treated as if held by the ultimate individuals. Options and certain convertible instruments are deemed ownership for this purpose. Many owners incorrectly assume that issuing a small percentage of stock to a few employees solves the problem. In reality, if a family group or a handful of insiders still controls more than 50 percent during the last half of the year, the test is met.
Thoughtful strategies exist but must be tailored. Employee equity programs and genuine third-party investors can broaden the shareholder base, but one must analyze whether shares are actually outstanding, vested, and non-redeemable, and how voting or value is measured. Transfers to trusts often do not help because attribution can still apply from the trust to the grantor or beneficiaries. Redemptions and recapitalizations can worsen the problem by concentrating value. Because the measuring period is the last six months of the taxable year, ownership changes must be effective and settled before that window closes. Forecasting cap table movements, accounting for options and warrants, and modeling attribution across entities are essential controls for closely held groups seeking to avoid the PHC designation.
Plan Distributions Deliberately: Cash Dividends, Consent Dividends, and Deficiency Dividends
If your corporation risks PHC status, strategic distributions can neutralize the tax by reducing undistributed PHC income. Classic cash dividends declared and paid before year-end are the most straightforward, but they consume cash and may not align with business needs. Two lesser-known tools are particularly powerful. A consent dividend allows shareholders to consent to treating a specified amount as a dividend for tax purposes without an actual cash payment. Shareholders include the amount in income and increase their basis, while the corporation reduces undistributed PHC income accordingly. Strict procedural requirements apply, including timely shareholder consents and information reporting.
If the IRS later determines a PHC tax deficiency for a closed year, a deficiency dividend can mitigate the tax. This mechanism permits a corporation to make a qualifying dividend after the fact and treat it as paid for purposes of reducing the previously computed undistributed PHC income, subject to a detailed claim process and deadlines. Both consent and deficiency dividends are technical and involve interplay with earnings and profits, shareholder-level reporting, and state conformity. Errors—such as misstating earnings and profits or missing election windows—are frequent and costly. Involve experienced counsel to draft resolutions, coordinate shareholder communications, and prepare the required statements and schedules.
Evaluate Entity Choice and Elections: S Corporation and Pass-Through Alternatives
One structural solution is to elect S corporation status or operate through a pass-through entity such as a partnership or LLC taxed as a partnership. The PHC tax applies to C corporations, not S corporations. However, this is not a universal cure. S corporations face their own regimes, such as tax on excess passive investment income when the S corporation has accumulated C corporation earnings and profits, and the built-in gains tax when converting from C to S within the recognition period. In addition, eligibility constraints, shareholder consent requirements, and state tax regimes must be respected. The “fix” can introduce new complexities that outweigh the benefit if not evaluated comprehensively.
For groups with multiple businesses, a hybrid approach may be optimal: operate active businesses in pass-through entities while maintaining a C corporation for specific purposes, or convert a passive C corporation into a regulated investment entity if appropriate. The decision matrix should include: shareholder tax brackets; ability to distribute cash; expected exits; need for retained earnings; compensation planning for owner-employees; state taxes; and creditor concerns. Changing entity classification is a major transaction with ripple effects on contracts, compensation plans, basis, and tax attributes. The choice should be modeled over a multi-year horizon with sensitivity analyses, not made reflexively in response to a single PHC exposure year.
Coordinate With the Accumulated Earnings Tax and Other Overlapping Regimes
Laypeople often conflate the personal holding company tax with the accumulated earnings tax (AET). They are separate and can apply simultaneously. The AET penalizes unreasonable accumulations of earnings and profits, regardless of whether income is passive or active. The PHC tax penalizes undistributed PHC income in a closely held setting. A dividend declared to manage PHC exposure may also address AET risk, but not always. The reasonable needs of the business standard under AET demands its own evidentiary support: budgets, board minutes, capital expenditure plans, debt covenants, and working capital analyses.
Other regimes can intersect as well. The net investment income tax at the shareholder level can affect after-tax outcomes when using distributions to purge PHC exposure. State-level conformity to PHC concepts varies; some states ignore PHC, while others adopt analogous provisions or impose their own penalties for undistributed passive income. International structures introduce additional layers, including Subpart F, global intangible low-taxed income, and passive foreign investment company rules for shareholders. Coordinated planning across these regimes is essential; solving the PHC problem in isolation is a common, and costly, mistake.
Implement Year-Round Controls: Forecasting, Documentation, and Governance
PHC risk management is a year-round discipline, not a December exercise. Establish governance that forces early visibility into the PHC tests. At a minimum, management should receive quarterly dashboards showing: ownership concentration (including constructive ownership metrics); current AOGI and PHC income components; projected year-end distributions; and the expected impact of intercompany transactions. Internal controls should require review of any proposed loans to affiliates, new licensing arrangements, or asset leasing programs for PHC implications before execution, not after.
Documentation wins disputes. Maintain schedules that reconcile subsidiary dividends to their sources of income for look-through purposes. Keep contemporaneous evidence of services provided by employees when charging fees to affiliates. Record board deliberations explaining why particular distributions were declared or deferred and how those decisions balance PHC exposure against business needs. When using consent dividends, preserve signed consents, shareholder notices, and computations of earnings and profits. These practices both improve outcomes on examination and create the institutional muscle memory that prevents avoidable mistakes.
Concrete Strategies to Reduce PHC Exposure Without Derailing Operations
The following tactics are frequently effective when tailored and supported by facts and documentation. First, replace related-party interest income with equity where feasible, and fund the parent through look-through-eligible dividends. Second, accelerate or expand bona fide operating activities that produce non-PHC income, such as adding service lines staffed by employees or acquiring an operating business that aligns with strategic goals. Third, when rental operations are significant, structure them to meet the rental exception by ensuring rents comprise at least 50 percent of AOGI and by bearing real landlord responsibilities, with leases and policies that reflect that reality.
Additional levers include: re-cutting personal service arrangements so that contracts are with the corporation, services are performed by teams rather than indispensable shareholders, and compensation reflects market norms; deploying consent dividends to reduce undistributed PHC income without impairing liquidity; and, if ownership concentration is the only failing, broadening the shareholder base through genuine issuances to employees or investors, mindful of attribution. Each step requires vetting against financial covenants, licensing and regulatory constraints, and tax basis and earnings and profits consequences. A plan assembled hastily to “check boxes” tends to increase audit risk and produce uneven results.
Representative Pitfalls and How Professionals Address Them
Common pitfalls recur in closely held groups. A parent company that holds intercompany notes and trademarks, charging interest and royalties to operating subsidiaries, often ends up with PHC income at the parent while starving the subsidiaries of profits. The intended “tax efficiency” backfires. Professionals typically restructure by capitalizing the parent’s investment as equity, repapering IP arrangements or consolidating IP into the operating entity, and paying dividends supported by the look-through exception. The reorganization includes a careful mapping of transfer pricing, state nexus, and contractual consent requirements to prevent collateral damage.
Another frequent scenario involves service businesses where the principal owner personally signs customer contracts. Even if staff perform substantial work, the personal service contract rule can sweep revenue into PHC income. The fix requires revising contracts to name the corporation as the service provider, building teams that do not rely exclusively on the owner for performance, and paying the owner reasonable W-2 compensation rather than channeling earnings as dividends or “management fees.” Documentation of workflows, quality control, and training supports the position that the corporation, not the owner, earns the revenue. These are not cosmetic changes; they must reflect the actual conduct of the business.
When to Engage Professional Help and What an Engagement Typically Covers
Owners often underestimate the complexity of PHC planning because they focus on one apparent lever—such as paying a dividend—without modeling the downstream effects on capital needs, debt covenants, state taxes, and shareholder-level consequences. The prudent approach is to engage an advisor who is both an attorney and a CPA to run a comprehensive project. A typical engagement includes: reconstructing the current-year AOGI and PHC income by category; modeling year-end scenarios for distributions and consent dividends; stress-testing ownership against constructive ownership rules; reviewing intercompany agreements; and assessing the viability of structural options such as S corporation election or subsidiary realignment.
The deliverables should include an implementation roadmap with board resolutions, updated intercompany contracts, dividend and consent dividend documentation, pro forma financial schedules, and a calendar of compliance filings, including the corporate return attachments that report PHC computations. The advisor should also train finance staff on maintaining the necessary schedules quarterly. This process is not overkill; it is the level of rigor necessary to make sustainable changes and to defend positions on examination. Given the stakes, especially for corporations with significant investment income or complex ownership, professional guidance is not optional—it is foundational to achieving durable results.
Key Takeaways You Can Act On This Quarter
To move from awareness to action, focus on a streamlined set of immediate tasks that meaningfully reduce risk while you design longer-term structural solutions. First, compile a year-to-date PHC diagnostic: quantify AOGI, classify income streams precisely, and project year-end results. Second, map ownership, including attribution and options, for the last six months of the year; identify any impending changes that could tip the stock ownership test. Third, identify intercompany interest, royalties, and rents and evaluate replacements with equity funding or look-through-eligible dividends. Fourth, prepare board-ready scenarios for cash dividends versus consent dividends, with cash flow and shareholder tax impacts side by side.
In parallel, initiate the documentation rescues that take time: revise personal service contracts to reduce dependence on shareholder performance; strengthen employee staffing and timekeeping for service lines; and assemble schedules that support the rental or dividend look-through exceptions where relevant. Finally, schedule a strategy session with qualified counsel to review entity choice, including whether an S corporation election or pass-through realignment is warranted next tax year. Acting methodically on these items establishes control over the PHC narrative and keeps options open, rather than forcing panic decisions in the final weeks of the year.
