Michigan Law Review Volume 63 Issue 3 1965 Personal Holding Companies and the Revenue Act of 1964 Jerome B. Libin Member of the District of Columbia and Illinois Bars Follow this and additional works at: https://repository.law.umich.edu/mlr Part of the Business Organizations Law Commons, Legislation Commons, Oil, Gas, and Mineral Law Commons, Taxation-Federal Commons, and the Tax Law Commons Recommended Citation Jerome B. Libin, Personal Holding Companies and the Revenue Act of 1964, 63 MICH. L. REV. 421 (1965). Available at: https://repository.law.umich.edu/mlr/vol63/iss3/2 This Article is brought to you for free and open access by the Michigan Law Review at University of Michigan Law School Scholarship Repository. It has been accepted for inclusion in Michigan Law Review by an authorized editor of University of Michigan Law School Scholarship Repository. For more information, please contact [email protected]. PERSONAL HOLDING COMPANIES AND THE REVENUE ACT OF 1964 Jerome B. Libin* Y 1964, many years had elapsed since significant changes were B made in the federal income tax treatment of so-called "personal holding companies." For that reason alone, any amendments con­ tained in the Revenue Act of 1964 that dealt with personal holding companies would have deserved attention. But the fact is that the changes made by the 1964 Act are so powerful in their thrust that they require the most careful kind of study by every practitioner charged with advising closely held corporations. Since the new provisions are rather complicated in nature, such a study cannot lead to a full understanding of their scope and effect without a proper appreciation of the reasons behind their enactment. !. INTRODUCTION A. The Problem in General Marked differences in the taxation of income based solely upon the nature of the earning entity have long stimulated fertile imagina­ tions interested in achieving significant tax savings. Wealthy indi­ viduals with sizeable amounts of investment income would particu­ larly benefit if careful planning could prevent a substantial portion of their income from being subjected to a federal tax bite. To serve this end, unquestionably the most popular technique employed has been the use of a corporation to conduct one's business or invest­ ment activities with little or no distribution of corporate earnings. Income generated in this manner would be taxed only at relatively low corporate rates, and a much greater proportion of total earnings could thus be accumulated and held available for later use in what­ ever manner was desired. B. Initial Congressional Approach to the Problem Since the revenue laws are designed, in general terms, to tax all income that is "fairly" attributable to each particular taxpayer, Congress recognized from the outset that certain safeguards would be needed to thwart schemes formulated for the sole purpose of escaping taxes that should fairly be incurred. In fact, the Revenue Act of 1913, our first modem-day income tax act, was partially de- • Member of the District of Columbia and Illinois Bars.-Ed. [421] 422 Michigan Law Review [Vol. 63:421 signed to reduce the potential use of a corporation for just such a purpose. To blunt the effectiveness of using the corporate form to escape individual income taxes, the 1913 Act contained a provision that taxed directly to individual stockholders their pro rata share of any corporate earnings that had been accumulated rather than distrib­ uted if the purpose of the accumulation was avoidance of the surtax then imposed on individuals receiving dividend income.1 By way of presumption, it was further provided that, if the corporation in question was a "mere holding company" or if earnings were accu­ mulated beyond reasonable business needs, that would be prima fade evidence of the proscribed purpose.2 Application of this pro­ vision could be prevented, however, if the Commissioner failed to carry the ultimate burden of proving that the accumulation of earn­ ings actually was for the purpose of avoiding the surtax on stock­ holders. Succeeding revenue acts contained accumulated earnings provi­ sions in essentially the same form.8 But, in 1921, as a result of certain language in the Supreme Court decision of Eisner v. Macombe~ that raised some doubt about the constitutionality of taxing stock­ holders on their pro rata share of undistributed corporate income, the burden of the tax was shifted from the stockholders to the cor­ poration, and the tax thus became an additional penalty tax at the corporate level.5 Imposition of the tax could still be prevented, however, if the Commissioner failed to establish that the accumula­ tion was for the proscribed purpose. In any event, regardless of the form of the tax on accumulated earnings, it did not prove to be a universal deterrent to tax avoidance schemes. Litigation under the applicable provisions found the Com­ missioner of Internal Revenue meeting with only limited success, and use of the corporate form to accumulate business and investment income continued in a relatively unabated manner.6 Finally, in 1933, a subcommittee of the House Ways and Means I. Income Tax Act of 1913, ch. 16, § II(A)(2), 38 Stat. 166. 2. Ibid. 3. Revenue Act of 1916, ch. 463, § 3, 39 Stat. 758; Revenue Act of 1918, ch. 18, § 220, 40 Stat. 1072. 4. 252 U.S. 189, 217-19 (1920). It seems clear, however, that the Court was con­ cerned with the constitutionality of a tax on the stockholder's share of earnings and profits "accumulated" by the corporation, rather than with a tax imposed at the time such profits were earned. 5. Revenue Act of 1921, ch. 136, § 220, 42 Stat. 247. 6. For a study of the early history of the accumulated earnings provision, see Rudick, Section 102 and Personal Holding Company Provisions of the Internal Re-ue­ nue Code, 49 YALE L.J. 171 (1939). January 1965) Personal Holding Companies 423 Committee undertook a special study of prevalent tax avoidance schemes. Its conclusion was that use of the so-called "incorporated pocketbook"-a corporation formed merely to hold securities or other income-producing property and to accumulate investment in­ come without making significant distributions to its stockholders­ had become perhaps the most prevalent tax avoidance scheme of all.7 The subcommittee recommended the enactment of new provisions to deal specifically with the incorporated pocketbook problem. The Treasury, although it found fault with the details of the subcom­ mittee's recommendations, nevertheless also urged the Congress to enact appropriate legislation. 8 The accumulated earnings provision was proving too easily avoidable in application due to the necessity of establishing a tax-avoidance purpose for the accumulation; it was the feeling of all concerned that more effective statutory provisions were needed to cope with the incorporated pocketbook type of abuse. !I. CONGRESSIONAL R.EsPONSE TO USE OF THE ''INCORPORATED POCKETBOOK'' A. The Revenue Act of 1934 The concern expressed by both the subcommittee on tax avoid­ ance and the Treasury provided the impetus for enactment of the first "personal holding company" provisions in 1934.9 The basic evil of the incorporated pocketbook was use of the corporate form to realize and accumulate purely passive investment income-income normally not associated with the active conduct of a business enter­ prise-in order to avoid the high individual surtaxes to which such income would have been subjected if personally realized by the individual investor. Regardless of the nontax reasons that might be advanced for use of the corporate form, the integrity of the federal income tax laws required that income earned by a mere corporate shell and not generally associated with corporate business activity should not be taxed at low corporate rates. Investment income in particular was considered more properly the subject of an individual income tax, since its realization is, in most cases, more directly asso­ ciated with individual rather than business activity. Both the rather descriptive "incorporated pocketbook" label and the more subtle "personal holding company" designation selected by the Con- 7. See SuncoMMnTEE OF THE HOUSE COMM. ON WAYS AND MEANS, 73D CONG., 2o 5~., PRELIMINARY REPORT ON THE PREVENTION OF TAX AVOIDANCE 6-8 (1933). 8. See H.R. REP. No. 704, 73d Cong., 2d Sess. 1 (1934). In a statement by then Acting Secretary Morgenthau, the Treasury criticized the proposed legislation on the ground that it was overspecific and thus could be too easily avoided. Id. at 8. 9. Revenue Act of 1934, ch. 277, § 351, 48 Stat. 751. 424 Michigan Law Review [Vol. 63:421 gress served to underscore the feeling that personal income-pro­ ducing activity should not be allowed to benefit from the relatively low, business-oriented corporate tax. Moreover, there was no good reason why a corporation used for such a purpose should not be the subject of a special tax without need for further proof of tax avoid­ ance motives. With this in mind, the House and Senate agreed upon a set of provisions that defined a "personal holding company" as any cor­ poration that derived at least eighty per cent of its gross income for the year from royalties, dividends, interest, annuities, and gains from the sale of stock or securities and that had more than fifty per cent in value of its outstanding stock owned by not more than five individuals at any time during the last half of the year. If a corporation qualified as a "personal holding company," it would be subject to a tax on its "undistributed adjusted net income" at the rate of thirty per cent on the first one hundred thousand dollars of such income and forty per cent on the excess of such income.