Editor’s Note: Walter E. Daniels is a founding principal in the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A.
________________________________________________________________________________________A typical biotech startup story might be as follows: Scott, Kent, Richard and Ben found a biotech company, LittlePharma. They raise a small amount of capital from a couple of angels so that LittlePharma is able to license two patents from Ivy Tower University for the development of a drug to cure a rare cancer. The first patent covers LittlePharma’s core technology. The second of the patents relates to a secondary business objective. LittlePharma decides to license the second patent to BigPharma for a large lump sum payment of $3,000,000 in hopes of using the money to develop the first patent over the next few years. This is particularly important because after the angel funding the founders own only 60% and thus they want to avoid the need to seek venture capital investment at this stage.

Unbeknownst to company, however, when LittlePharma closes the license deal with BigPharma, LittlePharma will be subjected to potential penalty tax liability in the amount of 15% of “undistributed personal holding company income” under a tax law anachronism known as the Personal Holding Company Tax (“PHCT”). This tax is in addition to the general corporate income tax. As a consequence it is possible that a big chunk of the money that was anticipated to be spent on development of the cancer drug will, instead, be paid to Uncle Sam. The PHCT is truly a trap for the unwary early stage technology company.

History of the PHCT

The PHCT is addressed in a part of the Internal Revenue Code entitled “Corporations Used to Avoid Income Tax on Shareholders.” The tax is a holdover from a period when maximum personal income tax rates were in excess of 70%. As explained in the Conference Report for the American Jobs Creation Act of 2004, “[t]he personal holding company tax was originally enacted to prevent so-called ‘incorporated pocketbooks’ that could be formed by individuals to hold assets that could have been held directly by the individuals, such as passive investment assets, and retain the income at corporate rates that were then significantly lower than individual tax rates.”

Now that the top corporate tax rate and the top personal income tax rate are close to each other, there is no present day public policy justification for the existence of this tax other than as a source of revenue generation. The tax continues to exist, however, and it applies regardless of whether the corporation was formed for the purpose of avoiding income taxes.

For some time many have recognized that the original justification for the tax no longer applies. Since 1964 the applicable PHCT rate has been lowered by Congress seven times, from a high of 75% to 15% today. The American Jobs Creation Act of 2004 eliminated the foreign personal holding company and the Senate version of the Act would have eliminated the domestic version of the tax, but this aspect of the Senate version did not survive the Conference Committee. So, while Congress has been chipping away at the tax, it can’t seem to strike the final blow. The PHCT remains in effect albeit at a lower rate, and a review of pending legislation indicates that there are no bills that would eliminate the PHCT other than bills which would replace the entire Internal Revenue Code and replace the PHCT with either a flat tax or a national sales tax.

To What Does the PHCT Apply?

Since the PHCT is still around it is important to figure out when it applies.

The PHCT is a tax on “undistributed personal holding company income” of a “personal holding company.” In order to fully comprehend this we need to focus on the two key terms: “personal holding company” and “undistributed personal holding company income.”

The first term to look at is that of a “personal holding company” or PHC because if there is no PHC the tax does not apply. To be a PHC two principal three tests must be met.

First, the tax applies only to C corporations. Thus, if income is being passed through or taxed directly to the shareholders via a corporation that has elected to be taxed under subchapter S or a limited liability company, the PHCT will not be a factor.

Second, there is an ownership test which is met if more than 50% in value of a company’s outstanding stock (including convertible securities) is owned, directly or indirectly, by or for 5 or fewer individuals. This would apply to the LittlePharma example, and would also apply to most technology start-ups that are not venture backed.

Finally, there is an income test. This is met if at least 60% of the Company’s adjusted ordinary gross income for the taxable year is personal holding company income. Personal holding company income is defined as that portion of adjusted ordinary gross income, which broadly speaking, is derived from dividends, interest, annuities, all royalties and license fees other than active computer software royalties or license fees, rents, mineral, oil and gas royalties, copyright royalties, produced film rents, and certain contracts with a shareholders who owns at least 25% of the value of the company’s stock.

Hence, if the young company’s lifeblood is royalty or license fee income, then the PHCT is designed to go after that lifeblood, over and above what would otherwise be due under the regular corporate income tax provisions. Stated differently, outside the world of oil and gas, only companies with intellectual property have royalty income. All high tech companies are based on intellectual property. By its very structure the PHCT has a particularly negative impact on young high tech companies…the very companies other public policies are designed to nurture because it is widely recognized that these companies are important for the Country’s future.

In the LittlePharma example, all of the license income would be personal holding company income. Ironically, this would still be the case even if the company had received a few Small Business Innovation Research Grants, in which case Uncle Sam would on one hand be providing cash to develop promising technology and at the same time be extracting a penalty tax on the private development capital received by the Company that would otherwise be used to further develop the technology. This is public policy conflict at its best.

Is There Any Way to Reduce the PHCT Burden?

The quick answer is that without further legislation there is very limited possible relief. Since the PHCT only relates to undistributed personal holding income, to the extent distributions are made, the amount of the tax will be reduced. A distribution (for example, payment of a dividend), however, defeats the young company’s purpose of using the money as capital to develop the technology.

Another consideration is that to the extent development expenses and other operating expenses are deducted, the amount of undistributed personal holding company income will be reduced and the PHCT tax will, as a result, also be reduced. In most instances, however, young tech companies are likely to use the development capital over more than one tax year and some of the expenditures may be required to be amortized rather than deducted. This means that tax would still take a bite. It also means that there is an incentive for the development capital to be spent before it otherwise should be spent, hardly a desirable public policy goal. It may be possible to negotiate the phasing of the income from the transaction to match expected allowable deductions, but of course this also has a risk that the later payments will not be received.

Finally, when setting up an entity for an early stage technology-based company that might fall within the PHCT provisions, it may be advisable to use a pass-through tax entity (S corp or LLC) rather than a C corporation, with the thought to converting later to a C corporation. Then again, the constraints related to these entities may lead to undesirable outcomes or may preclude their use. For example, it is often not possible to use other than a C Corporation for any number of reasons including that certain shareholders do not qualify to own shares in companies taxed under subchapter S, and investor shareholders often do not want to own equity in pass-through entities. Further, the conversion to a C Corporation down the line may have undesirable tax consequences.

Conclusion

Many small technology companies may outgrow the PHCT because the ownership mix is changed by participation of new investors with the result that the “5 or fewer ownership test is not met.” Still, it is unfortunate that the tax hits young companies in their most vulnerable state and might force companies to seek investment capital not otherwise needed.

As discussed above, there are many significant public policy concerns with the Personal Holding Company Tax, particularly when considering the impact of the tax on fledgling high tech companies. Those aware of the PHCT problem may wish to request of their Congressman and Senators that they take action to ensure that the remaining vestiges of the anachronistic PHCT are terminated once and for all.
_______________________________________________________________________________________

Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Walter E. Daniels concentrates his practice in the representation of rapidly growing companies, most of which are technology-based, and provides legal services in such areas as the corporate, financial and intellectual property needs of technology-based companies, including corporate finance, venture capital, and technology transfer. He serves on the Board of Directors of the Council for Entrepreneurial Development and the Statewide Advisory Board for the North Carolina Small Business and Technology Development Center. Questions or Comments can be sent to wdaniels@d2vlaw.com