Category: Corporations
Subject: Personal Holding Company
Title: Tax-Exempt Interest as PHC Income
IRC Sections: 103, 543, 61
Filename: 1215.html
Date Produced: 03/95

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Facts
A corporation plans to sell its only asset for cash and immediately liquidate into its parent. Neither the corporation nor its parent is an insurance company. The cash from the sale will be retained in the parent company. The parents's gross income from operations is minimal. If the cash resulting from the sale were invested exclusively in taxable, interest-bearing instruments, personal holding company tax would result.

Issue
As an alternative to taxable, interest-bearing instruments, if the corporation invested the cash in interest-bearing instruments producing income exempt from tax under Section 103, would personal holding company status or personal holding tax be avoided?

Answer
Tax-exempt interest does not enter into the determination of personal holding company status or personal holding company tax. Accordingly, if the corporation invested in tax-exempt bonds instead of taxable, interest-bearing investments, the personal holding company tax would be avoided. Note that there is some question about this conclusion if the taxpayer is an insurance company. See Sections 543(c), 832(b)(5), and 832(b)(6).

Discussion
A corporation is considered a personal holding company if certain stock ownership rules are met and more than 60% of its adjusted ordinary gross income consists of personal holding company income, including (among other things) interest. (Section 543(a)(1)).

Neither the Code sections directly related to personal holding company status and personal holding company tax (Sections 541 through 545) nor their related regulations specifically address the issue of tax-exempt interest.

Regulation Section 1.543-1(b)(2) provides that for purposes of the definition of personal holding company income, interest means any amounts received for the use of money loaned if such amounts are included in gross income. [Emphasis added.] Regulation Section 1.542-2 makes it clear that gross income for personal holding company purposes means gross income as defined by Section 61. Section 61 is the source of the all-encompassing rule providing that gross income means income from whatever source derived unless specifically excluded under Subtitle A of the Internal Revenue Code (which includes Code Sections 1 through 1564.)

Section 103, provides that gross income does not include interest on state and local bonds. Since Section 103 falls within Subtitle A of the Internal Revenue Code and since Section 61 allows exclusions from the Section 61 definition of gross income for specific exclusion items provided under Subtitle A, it is clear that gross income as measured by Section 61 does not include interest on state and local bonds.

Since gross income under Section 61 does not include interest on state and local bonds and since income for personal holding company tax purposes is derived from income as defined by Section 61, it is clear that interest exempt from tax under Section 103 is not included in the determination of personal holding company income. In essence, state and local bond interest, to the extent excluded under Section 103, is not counted as personal holding company income for determination of whether a corporation is a personal holding company. It is also clear that interest income exempt under Section 103 is not included in the determination of adjusted ordinary gross income. In essence, interest exempt from tax under Section 103 is excluded from both the numerator and the denominator of the 60% test provided in Section 542(a)(1).

The second part of the issue at hand is illustrated by the following question. Suppose that a corporation has already been determined to be a personal holding company by virtue of income from sources other than tax-exempt interest; is the determination of personal holding company taxable income affected in any way as a result of the existence of tax-exempt interest?

Under Section 541, personal holding company tax is equal to 39.6% of undistributed personal holding company income (UPHCI) as defined in Section 545. The starting point under Section 545 for determination of UPHCI is the taxable income of the corporation. Taxable income naturally would exclude interest exempt from tax under Section 103. Accordingly, the issue becomes whether there is a special adjustment for such interest in computing UPHCI. Section 545 provides a number of adjustments needed to convert taxable income to UPHCI. None of those adjustments relate in any way to tax-exempt interest under Section 103. Accordingly, it is clear that the existence of tax-exempt interest does not affect the computation of personal holding company tax.