Personal Holding Company Tax: the US trap for holding companies

Many successful European entrepreneurs who move to the US or invest there run into a tax pitfall that is barely known in Europe: the Personal Holding Company Tax (PHC tax). It targets certain corporations that mainly earn passive income, such as dividends or interest, in other words companies like the investment holding companies that are so common across Europe.

What is this special tax for?

The PHC tax was introduced to stop tax avoidance by keeping passive income inside corporations instead of distributing it. The background: in the US, individuals pay higher income tax rates than corporations. If wealthy individuals collected dividends through a corporation and kept them there, they could in theory pile up lightly taxed earnings at company level indefinitely and so avoid or defer tax at the personal level. The PHC rules are designed to prevent exactly that: they impose an additional tax at company level when passive income is not distributed.

1. What is a Personal Holding Company?

Under US tax law, a corporation is classified as a Personal Holding Company (PHC) if it meets two key conditions:

a) Income test:
At least 60% of total income comes from passive sources, for example:

• Dividends

• Interest

• Royalties

• Rents

• Income from trusts or bonds

• Capital gains under certain conditions

b) Stock ownership test:
More than 50% of the shares are owned by five or fewer individuals on the last day of the tax year (directly or indirectly, for example through foundations or trusts).

If both tests are met, an additional US corporate tax of 20% applies to the undistributed passive income.

2. The 80% rule: the holding company exception

There is, however, an important exception that many entrepreneurs don't know about:
If a company holds at least 80% of the voting shares in one or more operating subsidiaries, certain dividends from those subsidiaries do not count as PHC income, even though they would otherwise be passive.

Example:
A US holding company owns 100% of an operating subsidiary that actively generates revenue. The subsidiary pays dividends.
→ These dividends are not PHC income as long as the stake is at least 80%.
→ The holding company is treated as serving an active business function rather than existing purely to avoid tax.

But watch out: the exception does not apply if the holding company owns less than 80% or if the subsidiary itself has no active business.

3. Worked example: the PHC tax in practice

A German entrepreneur now lives in Austin, Texas, and sets up a corporation there (a C Corporation) that holds stakes in other US companies. In the tax year, this Texas corporation receives the following passive income:

• Dividends from several listed US corporations: $100,000

• No distribution to the owner

So the corporation meets:

• Income test: 100% passive income → met

• Stock ownership test: the entrepreneur owns all the shares → met

Result: the company is a Personal Holding Company.
Consequence: an additional 20% corporate tax applies to the undistributed $100,000, which means:

PHC tax: $20,000

This $20,000 is due on top of the regular 21% federal corporate tax, unless it is offset by other expenses.

Effective tax burden:

• $21,000 corporate tax (21%)

• $20,000 PHC tax (20%)
  → Total tax: $41,000 (41%) on passive, retained income

4. Why does this hit European entrepreneurs in particular?

Across Europe it is common practice to pool assets or business stakes in investment holding companies or personal holding companies. These structures:

• Earn almost exclusively passive income (dividends, interest, capital gains)

• Are controlled by a handful of individuals

• Rarely distribute profits, or do so deliberately later

In Europe, these structures are tax-efficient.

From a US perspective, though, the PHC trap looms once you become US resident or invest in the US.

If you move your residence to the US in particular, the following applies:

The US tax authorities often classify such companies as foreign holding companies. That triggers extensive reporting obligations to the IRS. US taxpayers (anyone resident in the US or holding a green card) must then file every year, among other things:

• Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations)

• Schedules G, H and M (depending on the structure and transactions)

• where applicable, Form 8938 (FATCA)

• FBAR/FinCEN 114 (for bank balances over $10,000)

even if nothing at all is distributed.

One group is hit especially hard and is often unaware of the problem:

Startup founders who hold their stake in an operating company through a personal holding company, a very popular model in Europe for deferring tax and protecting assets.

Holding companies like these:

• often meet the criteria of a Personal Holding Company from a US perspective,

• are treated as foreign holding companies with extensive reporting duties once you move to the US,

• can trigger the 20% PHC corporate tax by retaining profits.

Important: even if the operating company itself is active, it is enough that the holding company has no operating functions, meaning it only receives dividends or holds stakes.

What about tax treaties?

Many entrepreneurs wrongly assume that the tax treaty between their home country and the US protects them from these consequences. That is only partly true:

• A treaty prevents double taxation through tax credits, but it does not protect you from special regimes such as the PHC tax, Subpart F income or GILTI.

• The reporting obligations also remain in full. The treaty has no effect on them.

• With passive income, an additional US corporate tax can still arise, for example if the income is retained in the company.

5. Risky even without moving: PHC exposure in US holding structures

The PHC rules don't only affect people living in the US. Anyone who sets up a US holding company (for example a Delaware corporation), say to hold stakes in international businesses, can be caught too:

• If the holding company earns mostly passive income

• And the shares are owned by a small group of individuals (for example through a holding company)

Important: even if the owner lives outside the US, the PHC tax is levied at the level of the US company, regardless of any tax treaty.

6. When does the PHC tax not apply?

The PHC tax does not apply if:

• Less than 60% of income is passive
  → for example operating business, active trading, consulting services, etc.

• The shares are not mostly owned by five or fewer individuals
  → for example when ownership is spread across several investors or family members

• The 80 % exception applies because the company holds large stakes (at least 80 %) in operating subsidiaries

• It is a tax-transparent structure, such as a US LLC with disregarded entity status

7. Common pitfalls

Many business owners assume that a foreign company is "invisible" to the US tax system, or that they can simply keep using their holding structure from home. That is a dangerous mistake:

• The US tax authorities classify a foreign limited company as a corporation by default

• The company is subject to reporting obligations (e.g. Form 5471)

• It may also be hit by Subpart F, GILTI or, indeed, the PHC tax

Even holding investment income without distributing it can lead to a heavy tax burden.

8. What are the alternatives?

If you are moving to the USA or investing there, review your holding structure early. There are US-compatible alternatives that do not trigger the PHC trap:

a) US Limited Partnership (LP):

• No corporate tax at the LP level

• Flexible ownership arrangements

• Not a PHC

b) US LLC with disregarded entity status:

• Income is attributed directly to the member

• No separate corporate taxation

• No PHC tax

c) Check-the-box election for foreign companies (Form 8832):

• The company is treated as a partnership or disregarded entity for tax purposes

• The PHC rules no longer apply

9. How is holding income taxed in the USA?

The USA has a complex but also advantageous set of rules for taxing holding companies. Structure your investment income correctly and you can claim substantial tax breaks, in particular through the Dividends Received Deduction (DRD) and special structures for selling subsidiaries.

a) Dividends: the Dividends Received Deduction (DRD) under §243 IRC

When a US corporation (e.g. a C Corporation in Delaware or Texas) receives dividends from other US corporations, it can exempt that income partly or fully from corporate tax, depending on the size of its stake.

DRD rates at a glance:

Example:
A Texas C Corporation holds 85 % of the shares in another US corporation and receives a dividend of $1 million.
→ The entire dividend is tax-free (100 % DRD).

Important: the 100 % DRD requires that the stake covers at least 80 % of the voting rights and 80 % of the value ("by vote and value"). The stake must also have been held for at least 46 days within a 91-day window around the ex-dividend date.

Watch out: the DRD does not apply to foreign corporations! Dividends paid by European companies to a US holding are generally subject to US corporate tax with no DRD.

b) Capital gains: selling subsidiaries

When a subsidiary is sold, the holding company realizes a capital gain, generally taxed at the regular corporate rate of 21 %.

Example:
A US holding sells 100 % of a stake with a book value of $2 million for $5 million.
→ Capital gain: $3 million
→ Tax: $630,000 (21 %)

Avoiding it with the "Warren Buffett" strategy: the share-for-share swap

Legendary investor Warren Buffett and his company Berkshire Hathaway regularly avoid taxable sales like these by using "tax-free mergers" or "share swaps".

Instead of being sold, the subsidiary is exchanged for shares in another company. This is tax-neutral as long as these conditions are met:

• It is a reorganization exchange under §368 IRC

• The acquiring company takes over substantial parts of the assets

• The exchange is made solely for stock, not for cash

• The holding company remains invested

Example:
Instead of selling the subsidiary for $5 million, it is exchanged for shares in a listed US company.
→ No taxable capital gain
→ The book values of the old stake carry over to the new one
→ Tax is deferred until the new shares are sold

The advantage:
Your wealth is "reshuffled" tax-free, without triggering the 21 % corporate tax on capital gains: a tool that matters enormously to business owners who think long term.

Holding or not: that is the question!

Know the rules on PHC taxation and you can not only avoid nasty surprises but, with smart structuring, also achieve legal tax optimization. Combining the dividends received deduction (DRD), share-for-share strategies and a well-designed holding architecture lets you manage investment income largely tax-free or at low tax within the US system, as long as you know the pitfalls.

And that is exactly where the risk lies for many European business owners: if you are not familiar with US tax rules or simply "import" European models, you may not only fall under the PHC tax but also miss out on legal tax breaks that the US system expressly offers.

Mount Bonnell Advisors is at your side, with in-depth expertise in US tax law. Whether you are structuring your holding, applying the DRD or planning to sell a company: together with you, we develop a solution that works internationally and is tax-optimized.

Book a consultation now