July 16, 2014
Hobby Lobby and the Tax Definition of Closely Held Corporation
Posted by Ellen Aprill

The Court’s conclusion that the “contraceptive mandate, as applied to closely held corporations, violates RFRA ” (slip op. p. 49), without defining closely held corporations, has led some commentators to look to tax law. See here, here, and here.

Leaving aside the opinion’s reference to reliance on state law and its observation that the case did not address the applicability of RFRA to public companies, as Usha has described, the use of tax law for this purpose strikes me as misplaced because of the inconsistency in the way tax law uses, and fails to use, the term “closely held.”  

Commentators have primarily relied on IRS Publication 542, Corporations, and the IRS website, Entities.  These sources explain that, in general, a closely held corporation is one that “has more than 50% of its outstanding stock owned  (directly or indirectly) by 5 or fewer individuals during the last half of the tax year” and “is not a personal service corporation.” Publications and the IRS website are not authorities on which taxpayers may rely.

This 50%/5 definition comes from Internal Revenue Code section 542(a)(2), where it functions as part of the definition of “personal holding company.”  (A personal holding company is one that meets the 50%/5 ownership tests and also has at least 60% of its adjusted gross income from certain kinds of investment income.) Section 542 itself, however, does not use the phrase “closely held  corporation.”

Some Code sections do use the term.  One establishes a special rule for documenting corporate charitable contributions of property to a “closely held C corporation.”  Sec. 170(f)(11)(B).  Treas. Reg. sec. 1.170A-13(c)(7)(i) defines the term to mean “any corporation (other than an S corporation) with respect to which the stock ownership requirements of paragraph (2) of section 542(a) [the 50%/5 definition] of the Code is met.”  Note, however, that this definition appears in regulations, not the Code. Another section of the Code, section 469(j)(1), involving the limitation of deductions for passive activity losses, also refers to “closely held C corporation.” Eventually, it gets to the 50%/5 definition, by cross reference to another section, section 465(a)(1)(B), which in turns refers to section 542(a)(2). Section 856(h) defines a closely held real estate investment trust by cross references to section 542(a)(2).  Section 6655, dealing with failure by a corporation to pay estimated tax, has special rules for closely held real estate investment trusts, but gives its own 50%/5 definition, rather than cross-reference to section 542(a)(2).  Section 4942, which imposes an excise tax on the failure of a private foundation to distribute its income, refers to special valuation rules for securities held in a “closely held corporation,” but neither the statute nor the applicable regulations define the term.

Examples from other sections demonstrate the variety of the ways the Code adapts the 50%/5 definition.  As noted above, section 465(a)(1)(B), which deals with amounts at risk, does not use the term “closely-held corporation. “  Section 460, which involves long-term contracts, has a set of rules for closely-held pass-thru entities, defined to have 50% or more of beneficial interests held by 5 or fewer persons. Section  460(b)(4)(C)(iii).  Section 1563(a)(2) uses a 50%/5 test in connection with the definition of a controlled group of corporations, but it  neither employs the term “closely-held” nor cross-references to sec. 542(a)(2).  The definition of a controlled foreign corporation in section 957 uses part of the definition – it requires more than 50% stock ownership by U.S. shareholders, defined in section 951(b) as those owning 10% or more by vote -- but neither uses the term “closely-held” nor the 5 shareholder limit.

Yet another Code provision, which I have not seen discussed in the blogosphere, gives a quite different definition of a closely-held business.  Section 6166 allows an extension of time to pay estate tax where the decedent’s estate consists largely of an interest in closely held businesses.   In the case of a corporation carrying on a trade or business, eligibility for this deferral requires that 20% or more in value of the voting stock of such corporation be included in determining the gross estate of the decedent or that the corporation have ”45 or fewer shareholders.” Obviously,  45 shareholders are many more than 5 shareholders.  (Several other provisions involving  estate tax use “closely held,” usually, but not always, cross-referencing section 6166.)

To complicate matters further, a number of Treasury regulations use “closely held” without definition and, in context, appear to be distinguishing those corporations that are publicly traded  from that are not. See, e.g. Treas. Reg. sec. 1.56-1(c)(6), Example 4; Treas. Reg. sec. 1.274-3(e ) (2); Treas. Reg. sec. 1.355-7(j), Example 5.

Some of the commentators linked above also suggest the possibility of using the requirements for a Subchapter S Corporation –a corporation subject to only one level of tax - as a possible definition of closely held corporation.  Although Chief Justice Roberts referred to “this type of Chapter S Corporation that is closely held” during oral argument, Transcript p. 52, nowhere does the opinion itself refer to tax law.   Furthermore, section 1361 now permits a Subchapter S corporation to have as many as 100 shareholders, more than twice the number of shareholders permitted in the estate tax provision regarding interest in closely held businesses. 

Thus, although the 50%/5 definition appears in a number of places, given all the different uses of “closely-held” in the tax statutes and regulations, tax law should not be the basis for understanding the meaning of “closely held corporations” in Hobby Lobby.

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