Introduction to MSOs

A Management Services Organization (MSO) is a business structure designed to provide administrative and management services to operating companies. These services can include staffing, human resources, IT, and accounting, among others. An MSO can enhance tax efficiency, increase cash flow, protect family wealth, and accelerate business growth by centralizing administrative functions, optimizing resource allocation, and leveraging economies of scale.

What is a Personal Holding Company?

A Personal Holding Company (PHC) is a corporation primarily owned by a small number of individuals and deriving a significant portion of its income from passive sources. According to the Internal Revenue Code (IRC), a corporation qualifies as a PHC if it meets both of the following conditions:

1. Ownership Test: More than 50% of the value of the corporation’s outstanding stock is owned, directly or indirectly, by five or fewer individuals.
2. Income Test: At least 60% of the corporation’s adjusted ordinary gross income is derived from passive sources such as dividends, interest, rent, and royalties.

Disadvantages of a Personal Holding Company

1. PHCs face several disadvantages compared to regular C corporations, including:
   Additional Taxation: PHCs are subject to an additional tax on undistributed personal holding company income at a rate of 20%. This tax is imposed on top of the regular corporate income tax, resulting in double taxation.
2. Increased Scrutiny: PHCs often attract closer scrutiny from the IRS due to their structure and the nature of their income. This can lead to more frequent audits and a higher likelihood of tax disputes.
3. Limited Income Sources: The passive income nature of PHCs restricts their ability to engage in active business operations, potentially limiting their growth and diversification opportunities.

Why an MSO is Not a Personal Holding Company

With proper design and structure, an MSO does not qualify as a PHC. Here’s why:

1. Active Business Income: Unlike PHCs, MSOs generate income primarily through active business operations. The income of an MSO is derived from management fees for services rendered to operating companies, rather than from passive sources such as dividends or interest.
2. Ownership and Structure: While an MSO may have common ownership with the operating companies it serves, it operates as a separate and distinct business entity. This includes having its own employees, bank accounts, and financial records, and conducting its business operations independently.
3. Documentation and Compliance: An MSO should maintain thorough documentation to demonstrate its active business purpose and compliance with regulatory requirements. This includes formal agreements, such as Management Services Agreements (MSAs), which detail the services provided and fees charged. Such documentation helps to substantiate the MSO’s active business operations and separate it from the characteristics of a PHC.

Story: Personal Holding Company vs. MSO

Imagine two entrepreneurs, Jane and Tom, who decide to structure their business operations differently. Both generate a net income of $5 million annually and accumulate earnings over time.
Jane’s PHC:
Jane sets up a Personal Holding Company (PHC) primarily earning income from dividends and interest on investments. Despite its initial simplicity, Jane soon faces the challenge of double taxation. Her PHC’s undistributed income is subject to an additional 20% tax, on top of the regular corporate tax. Over a few years, Jane’s PHC accumulates $5 million in earnings, which attracts even closer scrutiny from the IRS due to its passive income sources. Frequent audits and compliance headaches become the norm for Jane. Additionally, the IRS subjects her PHC to the Accumulated Earnings Tax (AET) because it appears that the company is retaining earnings to avoid shareholder taxes.
To illustrate the financial impact:

Corporate Income Tax (21%): $5,000,000 * 21% = $1,050,000
– PHC Tax (20%): $3,950,000 (remaining income) * 20% = $790,000
– Total Tax: $1,050,000 + $790,000 = $1,840,000
If Jane decides to distribute the remaining earnings as dividends:
– Dividend Distribution: $5,000,000 – $1,840,000 = $3,160,000
– Dividend Tax (qualified dividends at 20%): $3,160,000 * 20% = $632,000
– Total Tax Burden: $1,840,000 (corporate and PHC taxes) + $632,000 (dividend tax) = $2,472,000
Jane’s effective tax rate is significantly higher due to the PHC status and additional dividend taxes.
Tom’s MSO:
Tom establishes an MSO that provides active management services to several operating companies. His MSO charges fees for services such as HR, IT, and accounting support. By generating active business income, Tom’s MSO avoids the PHC classification. Over the same period, Tom’s MSO also accumulates $5 million in earnings. However, Tom’s MSO operates independently, with proper documentation and compliance measures, ensuring smooth operations and minimal IRS scrutiny. To avoid the Accumulated Earnings Tax (AET), Tom documents clear business reasons for retaining earnings, such as future expansions, improving operational capacity, and other legitimate business needs. This clear distinction in operations and compliance allows Tom’s MSO to thrive without the additional tax burdens and scrutiny faced by Jane’s PHC.

Accumulated Earnings Tax and Compliance

The Accumulated Earnings Tax (AET) is imposed on corporations that retain earnings beyond reasonable business needs to avoid shareholder taxation. To avoid AET, corporations must:

1. Document Business Needs: Clearly document the reasons for accumulating earnings. Legitimate reasons can include planned expansions, debt repayments, purchasing new equipment, or other business investments.
2. Maintain Detailed Records: Keep comprehensive records of all business plans, financial statements, and board meeting minutes where decisions regarding retained earnings are discussed and approved.
3. Demonstrate Active Business Purposes: Ensure that retained earnings are used for active business operations and not simply to defer taxes. This can involve reinvesting in the business, improving infrastructure, or expanding service offerings.

Conclusion

An MSO, when properly structured and managed, offers significant advantages in terms of tax savings, asset protection, and operational efficiency. By adhering to guidelines that emphasize active business operations, maintaining rigorous documentation, and seeking professional guidance, an MSO can operate as a legitimate and effective business entity without being classified as a Personal Holding Company. There is no way an MSO can be classified as a PHC because management fees are active income.

Guardian Tax Consultants Business Solutions

Guardian Tax Consultants (GTC) offers a comprehensive business solutions platform with our MSO program that addresses these risk points and provides confidence to business owners. Our team of experienced tax attorneys ensures that your MSO is compliant with all regulatory standards and operates efficiently to maximize your business growth. Find an experienced firm to provide you with clear guidance on MSO setup and compliance to make sure you do not run afoul of the personal holding company regulations.

References

IRS Arm’s Length Standard: https://www.irs.gov/businesses/international-businesses/arms-length-standard

Personal Holding Company: Everything You Need to Know: https://www.upcounsel.com/personal-holding-company

Entities 5 | Internal Revenue Service: https://www.irs.gov/charities-non-profits/entities-5

What Are Holding Company Tax Implications?: https://www.upcounsel.com/holding-company-tax-implications

Personal Holding Companies (Portfolio 797): https://pro.bloombergtax.com

The Personal Holding Company Trap: Federal Taxation: https://www.cpajournal.com

Avoiding Personal Holding Company Tax: https://www.henssler.com

The Curious Incident of the Personal Holding Company in the Nighttime: https://www.alvarezandmarsal.com