On the face of it, setting up a personal holding company sounds like a graceful means for a once-active business to pass into its golden years. Theoretically, the business emerges cash-rich following the sale of its assets, and has nothing better to do than sit back and rake in returns from its investments.

Unfortunately, the Internal Revenue Service takes a dim view of such tactics. To discourage "incorporated pocketbooks," by which the owners use the shell of a once-active business to defer taxes, the Internal Revenue Code has established strict disincentives that effectively turn the personal holding company into a negative tax shelter. A business's owners may discover their predicament too late to bow out of it without additional tax complications. But there's a way to use the code to advantage and distribute the value of the holdings of a PHC to its stockholders so that they can continue to invest without interruption.

The answer, suggests a New York City management company, is to merge the PHC into a mutual fund. If the mutual fund shares are then retained by the former PHC stockholders, tax benefits, rather than tax bites, accrue.

The deal is constructed in such a way that the PHC's assets are generally bought with mutual fund shares on a dollar-for-dollar basis. According to Neuberger & Berman Management, the New York firm that is suggesting merging PHCs into one of the mutual funds it operates, this tax-free reorganization is allowed under Section 368(a)(1)(C) of the 1954 code, which provides for an "acquisition by one corporation, in exchange solely for all or a part of its voting stock."

The tactic frees the PHC from the binds it may have created by not liquidating within a year of the sale of its assets as an operating company. In Section 337 of the code, the IRS allows such an immediate liquidation without taxing the corporation for capital gains it may have made on the sale, provided that intent is field within two months. But some owners may elect not to liquidate, intending to postpone personal capital gains taxes and thus keep the gross amount of their capital at work within the corporate shell.

The resulting entity, however, may fall into the IRS's definition of a personal holding company. The IRS considers a corporation to be a personal holding company if (1) five or fewer individuals own more than half the stock during the last half of the taxable year, and (2) 60% or more of the adjusted gross income is from such passive sources as dividends, interest, royalties, rents, and annuities. And here's where the problems begin.

Unless it's specifically tax-exempt, such income is taxable to the corporation. And if it's distributed to the shareholders, it is taxable again, only this time as ordinary income no matter how it was taken in -- as capital gain, tax-exempted, qualified dividends, or whatever. Even that might be tolerable if it weren't for one extra stipulation: If a distribution from income is not made, the code imposes a heady additional tax of 50% on the undistributed amount that is not tax-exempt.

Nonetheless, business owners may choose to embark on such a route, sheltering income by investing only in instruments whose return is tax-exempt. In that way, earnings can be retained within the corporation without penalty. But often this solution proves to be too severe a restriction as conditions change. What happens, for example, if there are capital gains to be taken as the tax-free portfolio appreciates? In that instance it might be risky to postpone cashing in simply because of the tax consequences. Or perhaps at certain times there will be better opportunities in common stocks or other taxable vehicles rather than in strictly tax-free instruments. Possibly one owner would like to liquidate and retire while the others don't, or perhaps one owner disagrees with the investment philosophy of his or her associates.

Merging the PHC into a mutual fund uncomplicates such matters. To avoid getting involved in any possible hidden liabilities, the fund typically agrees to buy out the assets of the company, rather than swap shares. Since after the merger there is no reason for the PHC to remain in existence as a business entity, under the reorganization it liquidates itself. The fund shares are distributed to the former PHC stockholders, who hold them at far greater advantage than their shares in the PHC.

Now any shareholder can cash out independently of the others, if he or she wants; the capital gains tax on that portion is paid at last. But a major advantage of owning the shares of a mutual fund as opposed to those of a PHC or liquidated corporation is that such shares can be sold off piecemeal, with the shareholder owing only that fraction of capital gain that those shares represent. Another advantage if the shares are kept is that capital gains earned by an open-end mutual fund are passed through directly to the shareholder. (In a closed-end fund, the tax usually is paid by the fund, and credit for payment given to the shareholder.) Nor is a mutual fund obligated to pay taxes on what CPAs call "tainted earnings" if they occur in a PHC -- dividends, interest, royalties, and so on -- as long as these are passed on directly to the shareholder.

There are other ancillary benefits. Having an individual's interests contained simply in mutual fund shares, for example, makes it easier to plan or settle an estate. And -- assuming the fund is itself well managed -- there may be free advice from the fund's high-priced investment experts, who come with the territory. Further, the diverse investments of a mutual fund are likely to satisfy the strata of a PHC's shareholders, from the income-protection needs of a retiree to the growth expectations of a younger wage earner. The fund must be selected carefully, however: Changing funds in this situation constitutes a taxable event.

To qualify as a merger "candidate," a personal holding company should have been in existence as a PHC for at least three years. Otherwise, according to Neuberger & Berman, the IRS will probably refuse to issue an advance ruling on the tax status of the merger. (Experienced tax counsel is needed to steer the PHC through the IRS.) And a PHC's investments ought to be in marketable securities. Lastly, it's a help if there aren't too many minority stockholders. If a PHC is unusually large or widely held, the reorganization might, in the eyes of the Securities and Exchange Commission, be similar to an offering of shares, and thus require additional legal procedures and costs.

Because such arrangements can get complex and need expert guidance past possible IRS snares, fees for packaging the merger are apt to run to $10,000 or more, says Neuberger & Berman. This sum covers lawyers, accountants, and documents, and pays for a presentation to the merging fund's board of directors, who must respond to SEC concerns regarding the effect on fund stockholders.

Though the mutual funds that Neuberger & Berman manage are willing to participate in such mergers, not all such regulated investment companies care to take on the scrutiny of the IRS and the SEC. But if the right fund can be found to match a PHC's stockholders' investment concerns, such a merger can be an effective way of closing the doors once and for all on a profitable business.