818 / How can the accumulated earnings tax and personal holding company tax impact a business’ choice of entity decision when a business owner is considering converting to a C corporation?

For many pass-through business owners, the choice of entity decision may be strongly impacted by whether the business intends to distribute most of its income to the owners each year (as many small businesses do). Regardless of the form the distribution takes, the double tax structure (discussed in Q Q 8581) that arises in the C corporation context will often result in a C corporation generating a higher effective tax rate, depending upon the business owner’s income tax bracket.

If a C corporation does not distribute most of its income, the accumulated earnings tax and personal holding company tax must be considered. Both taxes are designed to prevent a C corporation from stockpiling earnings within the corporate structure in order to avoid tax at the individual level. The 20 percent accumulated earnings tax applies when the corporation accumulates earnings beyond the reasonable business needs of the corporation. The 20 percent personal holding company tax can also become important for closely held corporations that derive more than 60 percent of adjusted gross income from passive investments (such as dividends, interest and rent).

Businesses that would most likely benefit from C corporation structure after enactment of the 2017 tax reform legislation generally include capital-intensive businesses, such as a manufacturing company that has a legitimate business reason for leaving large amounts invested within the corporation (e.g., for purchasing and maintaining equipment).