Closely Held Corporations vs. Personal Holding Companies: IRS Rules & Tax Insights (2025)

Starting or operating a business involves making critical decisions—and one of the most important is choosing the right business structure. Your business entity type directly impacts your legal protections, tax obligations, and how the IRS treats your income. Whether you're forming a closely held corporation, an LLC, or considering personal holding company (PHC) status, understanding these classifications can help you avoid costly surprises and minimize tax risks.

In this guide, we break down the key differences between closely held corporations and PHCs in clear, practical terms—so you can stay compliant, minimize tax risk, and make informed business decisions.

What Is a Closely Held Corporation? IRS Definition and Ownership Criteria

According to the IRS definition of a closely held corporation, the term applies when:

·         Five or fewer people own more than 50% of the company,

·         And it’s not a personal service corporation.

Real-World Example of a Closely Held Corporation

Suppose you and four of your friends—Anna, Ben, Carla, Dave, and Ella—launch a technology firm named ABCDE Solutions, Inc.

You all own 20% of the company shares:

·         Five people (you and your four friends) own 100% of the stock,

·         You all own an equal share (so nobody is in control),

·         The company isn't offering personal services, it sells software.

Because five or fewer individuals own more than 50% of the company, and it is not a personal service corporation, ABCDE Solutions is a closely held corporation.

What is a Personal Holding Company (PHC)?

Imagine a PHC to be a company that primarily generates income by relaxing and earning passive incomes such as interest, dividends, or rent rather than actively engaging in selling services or products.

To qualify as a PHC, a corporation must meet two tests:      

1.  The Income Test

At least 60% of its income (before deductions) must come from passive sources like:

·         Dividends (from investments)

·         Interests (from bank accounts or loans)

·         Royalties

·         Rents

·         Annuities

This doesn’t include regular business income from selling products or providing services.

2. The Stock Ownership Test

Five or fewer individuals must own more than 50% of the company’s stock (directly or indirectly) at any point during the last half of the tax year.

If you have a PHC, the IRS doesn't want you simply to keep income within the firm and not pay personal taxes. The IRS says that if your company isn't actively doing business and you're just holding investments to avoid taxes, we'll hit you with an extra tax.

Relationship Between Closely Held Corporations and PHCs

A Closely Held Corporation is characterized by its ownership, when five or fewer individuals own more than 50% of the stock of the company. A Personal Holding Company (PHC) passes that test of ownership but must derive at least 60% of its income from passive sources such as interest, dividends, or rent. In brief, all PHCs are closely held, but not all closely held corporations are PHCs because PHCs are also about how the company makes its money, not just who owns it.

Exceptions to PHC Classification

Even if a corporation qualifies as an ownership- and income-tested PHC, certain companies are excluded by default from being considered one under the IRS. Exceptions generally cover those companies which are themselves highly regulated or that serve a specific public purpose.

·         Banks and financial institutions: These companies engage in lending and investing but since they are already under tight regulations, they don't count as PHCs.

·         Insurance companies – Businesses that also involve significantly in passive income (such as premiums and investments) but are exempted due to the type of business they conduct.

·         Tax-exempt organizations – Charities and non-profits (e.g., 501(c)(3) organizations) are exempt from PHC requirements.

·         Foreign corporations – In the general case, foreign corporations that are created abroad are not PHCs.

Personal Holding Company (PHC) Taxation

If your corporation is a Personal Holding Company (PHC), it can be taxed with an extra tax over the standard 21% corporate tax on income. The additional tax, referred to as the PHC tax, is 20% of the corporation's Undistributed Personal Holding Company Income (UPHCI).

Understanding Undistributed Personal Holding Company Income (UPHCI)

UPHCI is mainly composed of passive income including dividends, interest, rent, royalties, and annuities that the business corporation receives but doesn't disburse to the shareholders. This tax aims at deterring the business from leaving the investment earnings within the organization so that they can prevent personal income tax payability by shareholders. The IRS, instead, wants the shareholders to disperse the earnings in the form of dividends so they're taxed based on the shareholders.

Example PHC Tax Calculation

Assume a corporation has a taxable income of $300,000 for the year. From this, we deducted the federal income tax liability of $100,250 and the dividends paid deduction of $19,000, but we added back a dividend received deduction of $25,000. After adjusting for these changes, the undistributed personal holding company income (UPHCI) of the corporation amounts to $205,750. This is passive income the company gained but failed to distribute to its shareholders. Because PHC tax is a flat tax of 20%, the company would pay $41,150 in PHC tax.

This is in addition to the common 21% corporate tax, and it is there to dissuade corporations from keeping passive income in an effort to allow shareholders to escape individual taxes. If corporations pay out earnings as dividends, they can usually escape this additional tax entirely.

What are the Filing Requirements for Personal Holding Companies (PHCs)?

First, the company submits Schedule PH, which is designated as U.S. Personal Holding Company (PHC) Tax and submits this schedule along with its Form 1120 which is, the U.S. Corporation Income Tax Return. This schedule computes whether tax on PHC is payable and, if so, in what amount. The due date of Form 1120 is 15th April thus the schedule is to be fixed to Form 1120.

Also, if the corporation expects to owe $500 or more in PHC tax for the year, it must pay estimated tax on Form 1120-W (Estimated Tax for Corporations). The payments are to be made in four equal amounts by the end of each quarter during the year.

How Water & Shark Helps with PHC and Closely Held Corporation Compliance

Knowing whether your company is subject to Personal Holding Company (PHC) rules is important particularly when it comes to avoiding surprise tax bills. With intricate ownership tests, income levels, and reporting requirements, the PHC tax can quickly sneak up on business owners. But with proper planning such as allocating income correctly and filing the proper forms you can remain in compliance and avoid unnecessary tax costs. At Water and Shark, we assist companies in navigating these complex tax waters with confidence and clarity. Whether you're structuring a new company or auditing an existing one, our professionals are here to assist you every step of the way.