How do you get around the problem of double taxation? This is the big question to solve for any client with a C corporation. Unfortunately, taxpayers will sometimes try to apply tax reduction strategies without realizing the limitations—and very real consequences—in place. A major example is the practice of using a C corporation as an income “parking lot.” Business owners may not mind the flat 21% corporate tax rate offered by their C corp. The problem is that second layer of tax when distributions are made to shareholders. But what if they just never distribute that income, and shareholders therefore never have to pay individual income tax? If a tactic sounds too good to be true, it probably is. In this case, the IRS has rules in place to prevent this kind of behavior: namely, the personal holding company tax.
The Consequence: A 20% Federal Penalty Tax
A business owner cannot simply stockpile money in a C corporation without distributing it. If they try to do so, they can get hit with a hefty 20% tax on that undistributed income. That’s on top of the 21% corporate tax they already owe. Now the big question is: does that apply to all C corporations and all income? If it did, this could create a lot of complications as the IRS tries to sort out who is holding income in the C corporation as a legitimate way to fund business operations and who is simply trying to avoid tax. To simplify matters, the IRS applies two tests to determine if a C corporation is functioning as a personal holding company.
Defining a Personal Holding Company
These are the two factors to watch out for, lest your client’s business veer into “personal holding company” territory…
- The stock ownership test. The IRS first looks at the number of owners and what percentage of the company they hold. If more than 50% of the corporation’s stock is owned by five or fewer individuals, it may be considered a personal holding company. The clever tax planner in you may already be asking, “What do they mean by ‘owned’?” Great question. Here’s the complicated answer: ownership can either be direct (shares are held in their own name) or constructive (shares are held indirectly). Because constructive ownership is part of the definition, this means ownership can be attributed to spouses, children, parents, siblings, partnerships, trusts, and estates associated with the shareholders.
- The income test: Secondly, the IRS looks at the percentage of passive income. If at least 60% of the company’s adjusted gross income (AGI) consists of passive income, the corporation may be considered a personal holding company. The natural next question: “What counts as passive income?” The range is wide, from investment earnings, interest, and dividends to royalties, annuities, and rents. This test really requires us to analyze the character of the income and whether the owners are materially participating, which can be tough to do in a C corporation. Note that there is an exception here for income from rent or royalties if specific active trade or business thresholds are met.
Let’s look at a common scenario where a business owner may unwittingly walk into the personal holding company trap. A high-income business owner decides to make investments through their C corporation to take advantage of that 21% tax rate. To avoid double taxation, they opt to keep the money in the C corporation. However, the investments start to perform unexpectedly well, and suddenly, that passive income makes up almost 60% of the corporation’s total AGI. Now that personal holding company tax is lurking on the horizon.
As their tax planner, you may be able to offer an easy solution. Make a distribution and focus on helping your client offset their personal taxable income rather than face that 20% penalty. In an ideal situation, you will have been working with the client long enough that this doesn’t sneak up on you, so that you are not in a hurry to make a distribution and can wait until a tax-advantaged moment.
The Best Tax Strategies Come Penalty-Free
A tax pro with a plan can still “wow” their clients with how low that C corporation tax bill can go. Taxpayers may not realize that there are simple strategies for reducing taxable income that don’t involve skating on the edge of the rules. For example, stockpiled cash can be used on federal and state income tax payments or payroll tax payments. State income tax payments can also be deducted as an “ordinary business expense,” thereby lowering the federal tax bill. For shareholders who work for the business, it may also be possible to offer cash benefits to cover their individual tax payments, which also conveniently lowers the company’s taxable income.
Good Tax Planners Know How to Play Within the Rules
The American Institute of Certified Tax Planners trains our planners to see opportunities where others only see obstacles. “Quick fixes” are not necessary when you have in-depth knowledge of how to push the right tax levers and generate legitimate savings. With the right training, you can make finding the tax savings strategies that work for each entity type—even the tricky C corporation—look deceptively easy.
Hone your expertise and become each C corp client’s favorite person—sign up to become a Certified Tax Planner.
