Using Personal Holding Companies to Defer Tax


High-net worth individuals (“HNWIs”) seeking to defer taxes on income derived from foreign stocks and foreign or U.S. bonds should consider implementing the structure above. Such a structure will be particularly effective where the investor will not need this money for 30-40 years.

Creating foreign source income in a foreign personal holding company allows that income to later be excluded under the “high-tax” exception to the Subpart F rules, if the foreign entity is subject to high income taxes in the foreign jurisdiction, as defined under Section 954(b)(4) of the Code. The high tax exception will apply when the foreign taxes are at least 90% of the highest tax rate applicable to US C-Corporations (“C-corps.”).

Accordingly, first, the HNWI must choose a foreign country that has a tax rate that is at least 90% of a U.S. C corporation’s tax rate (21% x .9 = 18.9%). Examples include the United Kingdom (19% tax) or Malta (35% tax but is 6/7th refundable, potentially). The high tax exception does not specify that you cannot later receive a refund on that high tax.

Sample fact pattern for this type of planning could be:

  • HNWI contributes after-tax dollars to a foreign corp., through a U.S. C corp., tax free;

  • Foreign corp. is owned more than 50% by U.S. shareholders and is thus a controlled foreign corporation (“CFC”);

  • Foreign corp. will qualify as a foreign personal holding company (“FPHC”)(IRC 954(c)(1)) by investing only in passive income (generally consisting of dividends, capital gains, interest, rents, royalties, and annuities) producing assets;

  • Foreign country rate of tax is 19% (UK); qualifying it under the high tax exception (IRC 954(b)(4)); and

  • Foreign corp. invests only in foreign source passive income producing assets (e.g., foreign stocks and bonds).

Note: Dividends from a U.S. corporation paid to a Foreign Corporation are subject to 30% withholding (unless reduced by a treaty, if applicable) while interest from U.S. bonds paid to a Foreign Corporation is not subject to U.S. tax due to the portfolio interest exemption under IRC 897(h). These are important considerations when determining what investments the Foreign Corporation should choose.

This structure avoids personal holding company (“PHC”) tax and avoids accumulated earnings tax that are associated with a U.S. C corp. A PHC is a C corporation in which at least 60% of its adjusted gross income is from passive sources (along with a certain ownership requirement). The PHC tax is imposed under Code Section 531 and is 20%. This is paid in addition to the federal income tax of 21%. Under Code section 542(c), the term “personal holding company” does not include a foreign corporation; therefore the personal holding company tax that is applicable to U.S. corporations is not applicable to FPHCs. Likewise, the accumulated earnings tax of 20% under Code Section 532 is only applicable to foreign corporations with U.S. source income. Here, we are proposing a structure that has no U.S. source income. If the Foreign Corporation is going to own U.S. source income producing assets more planning is needed.

FPHCs are governed by the Subpart F rules of Code section 954 because they are a component of foreign base company income. Then deferral occurs through the income not being currently subject to tax under the “high-tax” exception. This is effective from a time value of money perspective, since money is worth more now than in the future. Additionally, the foreign corporation is paying less on the interest income than would a U.S. C corporation (21% + 20% PHC tax) or pass-through owner (ordinary income rate of 37% + 3.8% NIIT).

Passing on wealth in this dynastic fashion can be an effective planning technique if, for example, the U.S. C corp. owner of the FPHC was an irrevocable trust with proper generation-skipping tax allocation.

Maria Moller