Summary of Case 66C: Alvin Bruce and Square One Inc

Problem 66C is a subsequent case resulting from an earlier case regarding the redemption of part of Alvin, Bruce and Frederics shares by Square One, Inc. After the redemption, Clarissa Kelly, who became the president of Square One, Inc. had to raise any issues that arose thereof. Square One, Inc. had invested a sizeable amount of its earnings from the shopping center in many marketable securities, and it was of the concern that any significant reduction in its rental income might present personal holding company problems.

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Now, according to the letter addressed by Clarissa, the companys accountants recently told the shareholders that Square One, Inc. might face these questions in the current year. She attached the income statement for the past year and the projected income statement for the current year to equip the associate with adequate information about the company. According to Clarissa, two events significantly affected the companys rental income. First, at the end of the previous year, the state highway condiment a substantial part of the land and improvements located on the western side of the plaza. Second, at the beginning of the current year, a severe fire consumed the part of the plaza leased to Montgomery Ward Department Stores, which caused a substantial decrease in the companys rental income.

Through this letter, Clarissa seeks advice on whether Square One, Inc. will have any personal holding company problems, and if so, what the steps to take to minimize such problems. Moreover, none of the current shareholders expects to be subject to high marginal rates of income tax in the current year. Additionally, Clarissa needs advice concerning a willingness by Golden Harbor, Inc., and Hargrove Enterprises to lease some of the presently vacant space in the shopping plaza to repay two to three years rent, which could amount to $400,000 to $600,000.

Is Square One Inc. a Personal Holding Company?

According to IRS Code 542, a personal holding company is any C corporation in which five or fewer shareholders own more than 50% of the value of its outstanding stock, directly or indirectly. Additionally, the company receives at least 60% of its adjusted gross income from passive sources. The IRS Code 543 lists the various benefits common to personal holding companies. They include dividends, rents, annuities, and income from estates and trusts (Whittington, & Delaney, 2010). Additionally, the include interest minus certain amounts excluded under IRS Code 543 (a) (1) and Code 543 (b) (2) (c), and royalties less certain expenses allowed under IRS Code 543 (b) (2) (b).

Square one, Inc. adjusted ordinary gross income = the corporations gross income minus adjustments allowed under Code 543 (b). Accordingly, based on the income statement of the previous year, the adjusted gross income will be $4,180,000 ($500,000 + $380,000 + $240,000) = $3,060,000. The percentage of this adjusted gross income that arises from passive income is $3,060,000/$4,180,000 * 100 = 73. Therefore, Square One, Inc. receives 73% of its adjusted gross income from rental income, investment interest income, and dividends, which is more than the set 60%. Similarly, less than five shareholders own more that 50% of the value of the outstanding stock, namely, Alvin and Bruce. Both shareholders own more than 50% of the outstanding stock from the indirect shares of their related shareholders, that is, Alvins children and Bruces wife. Therefore, Square One, Inc. is a personal holding company.

The PHC Tax that Square One, Inc would have to Pay

According to IRS Code 1.545-1, the undistributed personal holding company income is the amount subject to personal holding company tax imposed under Code 541. Square One, Incs personal holding company income consists of adjusted rental income, investment interest income, dividend income, and proceeds of Valued Use and Occupancy policy. It equals the adjusted ordinary gross income, which is $1,520,000. Therefore, since Square One, Inc is a personal holding company, it will pay a personal holding company tax of 28%*$3,060,000 = $856,800.

How to Avoid PHC Tax

There are several ways to avoid personal holding company tax. First, since one assesses the PHC tax on undistributed PHC income, a payment of a dividend will eliminate the tax (Abrams, 2013). If a projection of the taxable income can be made reasonably accurate, Square One, Inc. may take steps to pay dividends by the year-end. However, if the shareholders discover the PHC problem after year's end, Square One, Inc. may still avoid the PHC tax because the dividends-paid deduction comprises dividends paid on or before the 15th day of the third month after the close of the fiscal year (Whittington & Delaney, 2010). It is important to note that, these post-year dividends must not exceed the lesser of the undistributed personal holding company tax for the prior year. Nevertheless, if Square One, Inc. cannot deduct the posy-year dividends, it may advise the shareholders to file for a consent dividend, provided they file the permissions any time before the due date of the corporations income tax return.

Conclusion

In summary, Square One, Inc. passes the two tests that qualify it as a personal holding company, namely, the Stock Ownership Test and the Gross Income Test. Furthermore, only Alvin and Bruce own more than 50% of the outstanding stock of Square One, Inc. Similarly, Therefore, Square One, Inc. receives 73% of its adjusted gross income from rental income, investment interest income, and dividends, which is more than the set 60%, which is the required percentage to pass the Gross Income Test. Therefore, Square one, Inc. is subject to personal holding company tax. However, the corporation can avoid this tax by paying dividends to its shareholders. Similarly, it can advise the shareholders to file for a consent dividend any time before the due date of its income tax return. Therefore, the best recommendation to Square One, Inc. is to pay dividends to avoid the personal holding company tax.

References

Abrams, H. (2013). Federal Corporate Taxation. West Academic.

Whittington, R., & Delaney, P. R. (2010). Wiley CPA exam review 2010. Hoboken, N.J: Wiley.