Editor’s Note: Walter E. Daniels is a member of the Technology Group and the Business Section of Ward and Smith, 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 patent 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 the founders will own only 60% of LittlePharma after the angel funding and, thus, they want to avoid the need to seek venture capital investment at this stage.

Unbeknownst to the founders, 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 be paid, instead, 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explained in the Conference Report for the American Jobs Creation Act of 2004, “[t]he personal holding company tax was originally enacted to prevent so-called ‘incorporated pocketbooks’ that could be formed by individuals to hold assets that could have been held directly by the individuals, such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 the PHCT other than as a source of revenue generation. The PHCT 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 PHCT 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 tax, 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 PHCT, 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 designed to eliminate it.

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: “undistributed personal holding company income” and “personal holding company.”

The first term is fairly easy to understand. "Undistributed income" is income that is not distributed to the shareholders. This is normally income that has been retained by the company as working capital and for investment in the development of new technology.

The second term, “personal holding company” or "PHC," is more complex, but if there is no “personal holding company,” then there can be no “undistributed personal holding company income.” In order for a company to be deemed a personal holding company, three tests must be met.

First, the company must be a C corporation. 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 is a limited liability company, the PHCT will not apply.

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

Finally, there is an income test. This test 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, royalties and license fees (other than active computer software royalties or license fees), rents, oil and gas leases or royalties, copyright royalties, produced film rents, and certain contracts with any shareholder who owns at least 25% of the value of the company’s stock.

Hence, if a technology startup company’s lifeblood is royalty or license fee income, then the PHCT is designed to go after that lifeblood, over and above what otherwise would 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 still would 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, would be extracting a penalty tax on the private development capital received by the company that otherwise would be used to further develop the technology. This is a 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 relates only to undistributed personal holding company 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 possibility is to deduct development and other operating expenses, which would reduce the amount of undistributed personal holding company income, and thus reduce the PHCT. While this sounds good in theory, in most instances, young tech companies are likely to use these funds for development over a period of more than one tax year, which in tax terms means some of the expenditures must be amortized rather than deducted–which means that the PHCT still would 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 carries the 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 (subchapter S corporation 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 new investors change the ownership mix so that the “5 or fewer ownership individuals" test for a personal holding company is no longer 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 their representatives in Congress to take action to ensure that the remaining vestiges of the anachronistic PHCT are terminated once and for all.

© 2008, Ward and Smith, P.A.; 2006, Daniels, Daniels & Verdonik, P.A.

Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. 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. He is a member of the Technoloy Group and the Business Section of Ward and Smith, P.A. Questions or comments can be sent to wed@wardandsmith.com.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.