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, 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.
543(a) General Rule — For purposes of this subtitle, the term “personal holding company income” means the portion of the adjusted ordinary gross income which consists of:
543(a)(2) Rents — The adjusted income from rents; except . . . .
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.
543(a)(2) Rents — The adjusted income from rents; except that such adjusted income shall not be included if—
543(a)(2)(A) — such adjusted income constitutes 50 percent or more of the adjusted ordinary gross income, and
543(a)(2)(B) — the sum of—
543(a)(2)(B)(i) — the dividends paid during the taxable year (determined under section 562),
543(a)(2)(B)(ii) — the dividends considered as paid on the last day of the taxable year under section 563(c) (as limited by the second sentence of section 563(b)), and
543(a)(2)(B)(iii) — the consent dividends for the taxable year (determined under section 565)
equals or exceeds the amount, if any, by which the personal holding company income for the taxable year (computed without regard to this paragraph and paragraph (6), and computed by including as personal holding company income copyright royalties and the adjusted income from mineral, oil, and gas royalties) exceeds 10 percent of the ordinary gross income.
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. The adjusted income from rents (line 18c) is at least 50% of adjusted ordinary gross income.
Test 2. The sum of taxable distributions (Part VI, line 3) and the deduction for dividends paid after the end of the tax year (Part I, line 12) is at least equal to:
1. The excess, if any, of PHC income, over
2. 10% of ordinary gross income.
For this purpose, PHC income includes copyright royalties and adjusted income from mineral, oil, and gas royalties, but does not include the amounts from lines 18c and 22.
If both of the above tests are met, rents can be excluded from PHC income.
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.
543(a)(2)(B) — the sum of—
543(a)(2)(B)(i) — the dividends paid during the taxable year (determined under section 562),
543(a)(2)(B)(ii) — the dividends considered as paid on the last day of the taxable year under section 563(c) (as limited by the second sentence of section 563(b)), and
543(a)(2)(B)(iii) — the consent dividends for the taxable year (determined under section 565),
equals or exceeds the amount, if any, by which the personal holding company income for the taxable year (computed without regard to this paragraph and paragraph (6), and computed by including as personal holding company income copyright royalties and the adjusted income from mineral, oil, and gas royalties) exceeds 10 percent of the ordinary gross income.
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):
equals or exceeds the amount, if any, by which the personal holding company income for the taxable year (computed without regard to this paragraph and paragraph (6), and computed by including as personal holding company income copyright royalties and the adjusted income from mineral, oil, and gas royalties) exceeds 10 percent of the ordinary gross income.
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):
equals or exceeds the amount, if any, by which the personal holding company income for the taxable year (computed without regard to this paragraph and paragraph (6), and computed by including as personal holding company income copyright royalties and the adjusted income from mineral, oil, and gas royalties) exceeds 10 percent of the ordinary gross income.
$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):
equals or exceeds the amount, if any, by which the personal holding company income for the taxable year . . . exceeds 10 percent of the ordinary gross income.
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):
[the sum of dividends paid] equals or exceeds the amount, if any, by which the personal holding company income . . . exceeds 10 percent of the ordinary gross income.
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.