Smartmoney, Inc. was formed by three wealthy dentists to pool their investment funds. They each invested $200,000 in the corporation, which was immediately used to purchase stocks to be held as investments. The first year, the corporation received dividends of $70,000 and filed a tax return paying a corporation tax in the amount of $7,350 [($70,000 dividends - $35,000 DRD) × .21 = $7,350]. The

Question

IRS audits this corporation and sends a tax bill in the amount of $12,530 ($62,650 UPHCI × 0.20 = $12,530) plus underpayment penalty and interest. What is this additional tax and what should the dentists do about it? What action(s) do you recommend the corporation take for the tax year in question and subsequent tax years?

What will be an ideal response?

Answer 1

This additional tax that was imposed is the personal holding company tax. The dentists should arrange to have the corporation pay deficiency dividends so as to avoid the penalty tax. The interest and penalties that have been imposed cannot be avoided by the payment of the deficiency dividend. The dentists should consider liquidating the corporation and have the assets held individually by the shareholders. The liquidating distributions are eligible for the dividends-paid deduction and can reduce the UPHCI amount. An S election might be considered. It could alleviate the personal holding company problem for future tax years, but not for prior tax years.