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Closely held companies, part 1: How does the IRS define them?

Closely held businesses can sometimes seem synonymous with their owners. But for tax purposes, there are important respects in which that is not true.

In this post, then, we will ask and address the following question: How does the IRS define a closely held corporation?

The question is timely because the IRS recently differed from the Tax Court in a case involving delinquent payroll taxes at a company controlled by a husband and wife.

In that case, there were two tax delinquencies. One was for the married couple who controlled a company. The other delinquency was for the company’s payroll taxes.

It is important to be clear about how the IRS uses the term “closely held.”

In general, according to the IRS, a corporation is considered closely held if it meets a couple of different criteria. One is that more than half of the corporation is owned by five people or fewer, either directly or indirectly. The other criterion is that the entity is not principally engaged in providing personal services.

There are also various limitations on closely held corporations regarding how certain losses are treated for tax purposes, as well as on the compensation officers of the corporation can receive. And it is also important to realize that a "personal holding company" is another type of entity.

How does the IRS determine what constitutes “direct or indirect” ownership of a closely held business? These terms are defined in Publication 542.

In part two of this post, we will explore further how the IRS and the Tax Court view closely held corporations.

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