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If your corporation has sold out, the IRS may be after your "incorporated pocketbook"

Every entrepreneur daydreams of cashing out someday. Sure, there will be taxes on the sale, but then we can just invest in safe stocks and bonds and pay tax on the interest at the nice low 15 percent corporation tax rate, right?

20110716iabiz Be careful. A depression-era relic in the tax law could bite you.

The Personal Holding Company Tax arose during the Depression to get corporations to disgorge their accumulated cash to goose a staggering economy (sound familiar?). Over time, the justification shifted from stimulating the economy to preventing the shifting of income to an "incorporated pocketbook." The PHC tax hits "personal holding company taxable income" with a 15 percent tax, on top of the regular corporate tax.

The corporation sitting on cash after a successful asset sale is the classic candidate for a personal holding company tax. It can apply if "bad" income -- primarily investment income -- is at least 60 percent of business income, and more than half of the corporation's stock is held by five or fewer shareholders. Related shareholders count as one shareholder. Special rules allow banks and some other financial businesses to avoid the tax.

The PHC tax can crop up in more-surprising ways. For example, a subsidiary that is sitting on investment assets can end up paying PHC tax, even if the rest of the companies in the consolidated tax return have plenty of "good" active business income. A cash-rich corporation might run into this tax. So may a C corporation that loans money to related businesses.

S corporations don't pay Personal Holding Company tax, but those that are former C corporations face a similar tax. The S corporation version, the "Section 1375 tax," can result in the loss of S corporation status after three years. 

The surest way to avoid the PHC tax is to liquidate the personal holding company.  That can be painful, triggering both corporation and personal tax, but with capital gain rates at a historically low 15 percent rate, it may be time to bite that bullet.  If you think that PHC tax might apply to you, it's certainly time to talk to your tax advisor.

Flickr image courtesy SheriW under Creative Commons license.

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