REG CPA Practice Questions Explained: Personal Holding Companies

In this video, we walk through 5 REG practice questions about personal holding companies and the taxes associated with them. These questions are from REG content area 5 on the AICPA CPA exam blueprints: Federal Taxation of Entities.

The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.

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The Rules for Personal Holding Companies (PHCs)

A Personal Holding Company (PHC) is a closely held corporation that meets specific income and ownership criteria. The primary goal of the PHC status and the subsequent tax is to prevent the owners of closely held corporations from avoiding personal income taxes on distributed earnings.

Criteria for PHC Status:

1. Ownership Test: More than 50% of the value of the corporation’s outstanding stock must be owned directly or indirectly by five or fewer individuals at any point during the last half of the tax year.
2. Income Test: At least 60% of the corporation’s adjusted ordinary gross income must be from passive sources, such as dividends, interest, rents (unless derived from an actively managed real estate business), and royalties.

Example:

• Company Name: Cedar Grove Enterprises
• Tax Year Gross Income:
  • Dividend Income: $220,000
  • Interest Income: $100,000
  • Rental Income (non-active): $30,000
  • Consulting Service Income: $150,000
• Total Taxable Income: $500,000
• Ownership Structure: Owned by four siblings, each holding 25% of the stock.

Step 1: Ownership Test

• Criteria: More than 50% of the stock must be owned by five or fewer individuals.
• Analysis: Cedar Grove is owned by four individuals (the four siblings), which satisfies the ownership test because 100% of the stock is owned by fewer than five individuals.

Step 2: Income Test

• Criteria: At least 60% of the corporation’s adjusted ordinary gross income must come from passive sources.
• Calculation:
  • Passive Income Components:
    • Dividend Income: $220,000
    • Interest Income: $100,000
    • Rental Income (non-active): $30,000
  • Total Passive Income: $350,000
  • Total Income: $500,000
  • Percentage of Passive Income: ($350,000 / $500,000) * 100% = 70%
• Analysis: The passive income constitutes 70% of the total income, exceeding the required 60% threshold.

Conclusion: Cedar Grove Enterprises qualifies as a Personal Holding Company because it meets both the ownership test and the income test:

Dividends Paid Deduction

The dividends paid deduction is intended to encourage PHCs to distribute their income to shareholders. This deduction allows PHCs to reduce their taxable income by the amount of dividends they distribute, thus lowering their PHC tax liability.

• Dividends Paid: The deduction includes all distributions made to shareholders during the tax year. It includes cash dividends, property dividends, and certain distributions that are deemed dividends for tax purposes.
• Effect on PHC Income: To calculate the PHC tax, the total taxable income is adjusted by subtracting the dividends paid. This reduction directly impacts the amount of income subject to the PHC tax.

PHC Tax

The PHC tax is levied to penalize personal holding companies that choose to retain earnings rather than distribute them as dividends. This tax is meant to prevent these companies from benefiting unduly from tax deferral.

Tax Rate: Historically, the PHC tax has been imposed at a rate of 20% on undistributed PHC income. This rate applies to the net income remaining after accounting for dividends paid.

Calculation:

1. Determine PHC Income: Start with the corporation’s taxable income and make necessary adjustments to reflect the PHC income, adding back certain deductions and excluding non-PHC income as necessary.
2. Account for Dividends Paid: Subtract the total dividends paid from the adjusted PHC income.
3. Apply PHC Tax Rate: The remaining income, now classified as undistributed PHC income, is taxed at the PHC rate.

Example:

• Total Taxable Income: $800,000
• Dividends Paid: $300,000
• Adjusted PHC Income: $500,000
• PHC Tax: 20% of $500,000 = $100,000