PFIC Excess Distribution Calculation Example and IRS Form 8621
PFIC and the IRS
When it comes to offshore and foreign investments, it does not get much more complicated (for non-Business tax returns) than the dreaded PFIC Analysis. A PFIC is a Passive Foreign Investment Company and highly frowned upon by the IRS. As a result, the IRS has seemingly devised a scheme to penalize Foreign Mutual Fund investors while couching it as a “tax.”
The reason why this may impact you without you even knowing it is because even though you never intended on owning or investing in a PFIC, you may have inadvertently invested into a PFIC “accidentally” by investing in or having ownership of a foreign mutual fund.
In recent years, the IRS rules surrounding offshore investments have become so stringent that the IRS has essentially made the blanket statement that any foreign mutual bond is considered to be a PFIC.
Foreign Mutual Fund – No Distribution
When it comes to a foreign mutual fund or PFIC in general, if you have never made an election in years prior (see below), then you will not be taxed on the earnings unless they are distributed.
That is the default position (IRC Code Section 1291), BUT it is much worse than it may appear at first glance. Why? Because once the funds are distributed (aside from a distribution during the initial year of the investment) and an Excess Distribution is issued, the taxes are so outlandish that it is essentially a penalty more than a distribution.
Any benefit you may have thought you gained is not only wiped away, but the taxes and interest you end up paying will far exceed any taxes you would have paid on a comparable U.S. Mutual Fund.
Elections are alternatives to the general distribution rules. They are designed to try to ease the burden of foreign mutual fund distributions. The two main types of elections are the QEF (Qualified Elective Fund) and Mark-to-Market. We will not discuss these elections in this article, other than to say that either one of these elections may assist in reducing your tax burden.
With that said, these elections can be difficult to make and generally require at least some assistance and/or cooperation from the foreign mutual fund; good-luck with that, as not only does it defeat the purpose of having a foreign mutual fund…but what foreign investment fund is going to actually volunteer to be subject to U.S. tax reporting requirements.
Foreign Mutual Fund Distributions
In a US-based mutual fund (even if it contains foreign investments) there are general distribution rules and guidelines that the US mutual funds must abide by. Namely, the fund must distribute at least 90% of its annual income to avoid a second layer of taxation. Since a foreign mutual fund is not regulated by the US government, it does not have to meet/distribution requirements of a US mutual fund. This means your money grows, tax-free.
At first glance, this makes a foreign fund seem like a better deal than a US mutual fund – which it otherwise would be. Of course, the IRS does not want you to see it that way, and therefore devised a complex and complicated set of tax rules for foreign mutual funds. In order to try to explain this as simply as possible, we’re going to take a very basic example of a distribution and explain the process of how it works.
This is not intended to be legal advice. You can refer to the following example to gain a very basic understanding of PFIC concepts…but it is not a manual or representation of how you should conduct your analysis since every situation is different and this is a very complex area of tax law.
Foreign Mutual Fund Distribution – No Foreign Taxes
Let’s take India for example, as it is very applicable for our client-base.
It is very common for individuals from India who reside in the United States to continue investing overseas once they relocate to the U.S as a Citizen, Legal Permanent Resident or Visa-Holder (L-1, E-2, H-1B, etc.).
Under various nonresident tax schemes, India does not tax certain earnings.
With India, many individuals who are originally from India but residing in the United States still have investments in foreign accounts, such as Demat Accounts, FDs, PPFs, and Foreign Mutual Funds.
Example of the Excess Distribution Calculation
Let’s take Matthew. Matthew is originally from India but now resides in the United States. With the help of his father back in India, Matthew invested $200,000 in foreign mutual funds. For many years, there have been no distributions such as dividends or interest from the foreign mutual fund. In addition, Matthew has not sold any shares of the fund and never made any U.S. Tax elections.
Fast-forward to five years later and Matthew received a large distribution. It was a $20,000 dividend distribution, and the first and only distribution he has received from the foreign mutual fund.
The following is a breakdown of the tax analysis for this distribution:
- Is it an Excess Distribution? Yes. Even though this was the first distribution from the foreign mutual fund, it is not the first year of the investment (in which there cannot be an excess distribution because it is not in “excess” of any prior year distribution).
- What is an Excess Distribution? An excess distribution is the catalyst that sparks this complex tax analysis. Essentially, an excess distribution is a distribution in the current year, which exceeds 125% of the average of the three prior years. In this particular scenario, there were no prior distributions and this is not the first year of the investment, therefore it is an excess distribution.
- How do I analyze the distribution for tax purposes? Unfortunately, you know it’s going to be difficult when programs such as TurboTax do not even carry the form, your CPA never heard of the form, and the instructions themselves tell you to basically use a separate statement to determine the annual tax liability for prior years and literally block out the section of the 8621 form itself. See below for a numerical analysis.
- Why the Additional Tax? The IRS wants payback for the time your Foreign Mutual Fund was sitting overseas and growing – but not being taxed. Had the investment been in a U.S. mutual fund, it would’ve been distributed annually (even if immediately reinvested) and you would have been taxed (albeit at a lower tax rate). This is the IRS’ opportunity to get that money back from you.
- It Sounds Bad? It is. The IRS is going to tax you for each year you held the investment and the IRS is going to tax you at the highest ordinary income tax rate available each year for the portion of the investment earnings allocated for that year (even if you are not in the highest tax bracket). In addition, the IRS is going to tack on interest for the unpaid allocations that you didn’t pay timely, in accordance with the amount of tax allocated for each tax year of total tax amount, even though the tax amount is only being determined for the first time right now with this initial distribution…simple, right?
Let’s use some numbers:
Step 1: Determine the amount of the excess distribution. In this particular scenario, there were no prior distributions and therefore the total amount of the distribution will be considered an excess distribution (except for the current year distribution allocation will be taxed differently). It is a $20,000 Excess Distribution.
Step 2: Determine the holding period of the investment. In order to keep it simple, which it rarely ever is, lets say the holding period is exactly five (5) Years. That means the holding period was 1826 days (since at least one leap year must be included every 4 years)
Step 3: Divide the excess distribution by the total number of days in order to determine the amount of excess distribution allocated to each day in the holding period. If you happen to have paid foreign tax on any of the distributions, it should be noted at this time as well.
Step 4: Determine how many days in each year the investment was held. For example, if the investment was purchased on January 1 and sold exactly 5 years later, the number of days in each tax year would be 365 with one year being 366.
Step 5: multiply the number of days in each tax year the investment was held by the excess distribution allocated to each day. Using 2011 as one of the five tax years in this example, the $20,000 excess distribution would be divided by 1826 days is $10.95. The $10.95 is then multiplied by 365 days, which equals $3998.
Step 6: Determine the tax liability: Using the example above, the highest tax rate in 2011 was 35%. Therefore, you multiply $3998 (the allocation for tax year 2011) by 35% (the highest tax rate for that year) to determine the increase in tax for that tax year, which comes out to $1399. If you happen to have a foreign tax credit then it may be applied at this time but allocated accordingly.
- This is then done for each year and itemized separately per year.
Step 7: Interest: You are not done yet. From the IRS’ perspective, not only should you have been paying tax during each year that the money was not distributed (because you have not paid tax for years of undistributed earning) you now have interest due on the undistributed money — which is being taxed at ordinary income tax rates.
– Generally, in order to determine a rough estimate of your interest, you would take the applicable IRS Interest Rate, divided by the number of days in the tax year and then multiply it by the amounts of tax due along with the number of days the tax has not been paid. So for example, the 2011 tax due should of been paid by April 15, 2012 (remember, if you receive an extension that only applies to the filing date but not to the actual date of payment due, 2012) and if you have not paid that tax (how could you…you just learned about it with the initial distribution), the interest can be significant.
Step 8: Rinse, Wash, and Repeat. You must perform the same analysis for each year of the tax, with the understanding that it is rarely going to be 365 days for tax year. Rather, the year in which you purchase the investment in the year and the year in which the investment was sold will presumably be less than 365 days (unless you bought/sold on first or last day of the year).
Step 9: Current Year Distribution: The current year distribution will get taxed at your ordinary income tax rate, and not necessarily the highest tax rate (you do not get capital gains or qualified dividend treatment). In other words, the distribution allocated to the current year will go into your tax return calculation. The tax liability for the excess distribution will end up on line 44 of your 1040.
As you can imagine, depending on the amount of the distribution and holding period, once that foreign mutual fund has its first distribution (aside from the initial year of holding) and it is entirely an excess distribution, you may be paying well beyond 50% – 75% in tax liability, wherein the tax liability for a US mutual fund would have been a lot less.
Removing a Future Excess Distribution Tax/Penalty
The general proposition is that once an investment is once a PFIC, it is always a PFIC. The IRS has gone to great lengths to prove this point, including the fact that even if the investment itself is no longer a PFIC, it will still be considered a PFIC to the investor who invested in the fund.
In other words, once you own an investment abroad that is considered to be a PFIC, your best way to parachute out — short of selling the entire asset and taking excess distribution – along with taxes and penalties that can reach 100% value of the investment is to make a late election – if possible.
By making an election you may be able to limit the fines and penalties that the IRS levy against you at the time of an excess distribution (although a phantom Excess Distribution will be calculated at the time you make any late MTM election, outside of OVDP).
Mark-To-Market Election (MTM)
The purpose of this summary is to not get bogged down by all the nuances and technicalities of the election; rather, it is to attempt to assist individuals who may be considering making the election (usually through the OVDP process) to get a big picture understanding the pros and cons.
**As a side note, as of May 2017 the IRS will still not allow an individual to make a mark-to-market election if they are in the streamlined program (as opposed to traditional OVDP)
Understanding the MTM Election
Generally, in the United States a person is taxed when an event occurs. For example, if a person purchases a stock for $1 million and in three years the value has increased to $2 million, the person does not pay tax on the increase. Why? Because tax will not be realized unless an event occurs, such as when he sells the stock (presuming that at the time of the sale, the current sale value still exceeds the basis).
But First…A Little Background About Excess Distributions
Likewise, when a person has a PFIC, and they did not make an election, they are not taxed on the increase in value within the PFIC. Rather, the government saves up the tax whammy for when there is a distribution. Unless the distribution is made in the first year of the investment (as opposed to the first distribution, which could be several years after the initial investment was made), the person is going to be hit with an excess distribution.
In many situations, there was no distribution prior to the first distribution the person receives. In other words, there are not steady annual distributions to the investor each year (which could curtail an excess distribution issue), but after a few years there may be a distribution – of either interest, dividends, or capital gains.
Presuming that the distribution exceeds the average of 125% value of the three prior-year distributions, the IRS deems this distribution an excess distribution. In your mind, you should equate excess distribution with penalty.
Why? Because the person is taxed at an obscene tax rate, which can be summarized like this: the total value of the excess distribution is divided by the total number of days that it was held in the PFIC. Thereafter, the person is taxed per day at the highest Ordinary Income tax rate for the corresponding year for each day they held the investment, in addition to interest.
As an example, instead of a person being taxed at a 15% long-term capital gain tax rate, they will be taxed a 39.6% tax rate even if they themselves are not in the highest tax bracket. This is true as to the excess distribution portion, for every year the investment was held – aside from the current year, which is taxed at the taxpayers ordinary tax rate.
As you can imagine, depending on how long the investment was held and the amount of money distributed in the initial distribution, the tax rate can be very high. Moreover, the IRS will also require you make interest payments for each day that the investment was held. Thus, once you calculate the highest tax rate and multiply it by several years, in addition to multiple years of interest payments, the overall payment can reach more than 75% tax.
Therefore, if possible, sometimes it will benefit you to make an election. The MTM election is more common because the other election QEF, requires more complicity from the foreign investment fund – which is usually next to impossible. Why? Because why would a foreign investment company want to succumb to US tax laws, when it doesn’t have to for any other reason?
With the Mark-to-Market election, the investor is making the decision to pay tax on the gains each year, despite the fact that no money is being distributed from the fund. For example, let’s say David owns $100,000 worth of a foreign mutual fund. The fund does great, and David’s fund is now worth $120,000 on the last day of the year.
Even though the investment is not distributing any of the gain to David, he will still pay tax on the $20,000 gain. Moreover, David will pay tax at the ordinary income tax rate, and not any beneficial qualified dividend tax rate. In addition, it should be noted that when the fund loses money, David is highly restricted as to what losses he can take against the gains the already paid tax on.
Can Anybody Make the Election?
No. The election must be made timely and it must be in accordance with Internal Revenue Code section 1296 – which has very strict requirements. As a side note, if a person is submitting to the traditional Offshore Voluntary Disclosure Program (OVDP) they are allowed to make an MTM election at the time of the submission. Otherwise, they have to qualify for Reasonable Cause (see below)
What Are The Requirements?
The most important aspect may be that the stock must be marketable. What does that mean? It means that the stock is traded on a national securities exchange, which is registered with the Securities and Exchange Commission or the national market system in accordance with the securities and exchange act of 1934. Alternatively, the stock must be traded on any exchange or other market which the Sec. determines has rules adequate to carry out the purpose of this part.
(Leave it to the government to keep it nice and ambiguous)
In other words, it needs to be legitimate – and, if it’s not registered with the SEC or national market system, then you have to explain to the IRS why the particular type of stock is still valid and should be considered marketable for the election purpose.
The IRS also provides a catchall for regulated investment companies, which provides “In the case of any regulated investment company which is offering for sale or has outstanding any stock of which it is the issuer and which is redeemable at its net asset value, all stock in a passive foreign investment company which it owns directly or indirectly shall be treated as marketable stock for purposes of this section. Except as provided in regulations, similar treatment as marketable stock shall apply in the case of any other regulated investment company which publishes net asset valuations at least annually.”
Why Would Somebody Want To Make This Election?
There are many reasons why, but the most important reason is to avoid the excess distribution. While most people want to delay paying tax as long as they can, with a PFIC — that delay can come at a very stiff price. With an MTM election, it may seem absurd the pay tax on money that is not distributed to you, but the flip-side is that it will help avoid an even larger excessive distribution tax in the future.
In many foreign investments (just as in US investments), the investment does not pay-out during the initial phase of the investment. Rather, many years down the line once the company or investment is successful, then the investor (you) are rewarded with a nice distribution.
With the excess distribution tax/penalty scheme, the longer that the investment remains profitable — but is not being distributed to you — is another year and wish you be paying significant taxes and interest.
Making The Election Late (Excess Distributions)
Outside of the specifics surrounding MTM and OVDP – as with most late elections or other mistakes you want to remedy with the IRS – you can generally make a late Mark-to-Market election under the proper circumstances. Without going into specifics, this generally means that you can show reasonable cause as to why the election was not made earlier.
Please keep in mind, that you will still have to take one excess distribution at the time you make the late election for the prior year gains that were not previously taxed.
For example, let’s say you purchase the fund in 2005 for $100,000. It is now 2017, and after hanging out with your dorky tax lawyer friend, you realize that he is correct and that your foreign mutual fund is considered a PFIC. You also realize that the fund is expected to continue to grow indefinitely. Thus, in 2017 when your fund is worth about $400,000, you decide to take a late mark-to-market election.
While going forward you can use the MTM rules, for the prior years — starting from the cost basis (which is the value when you purchased it) and through the current value of the investment — you will have to perform a phantom excess distribution analysis (Phantom, because based on these facts you are not actually receiving any distribution from your foreign mutual fund).
Failure to File Form 8621 and…
If the analysis above is not enough to give you stomach pains, keep in mind that if you have not filed a proper 8621 for a prior year, then your tax return is not considered complete and the IRS can try to come after you for as long as they would like. With that said, arguments have been made that if the statute of limitations have already expired on auditing your prior returns, then the IRS should be limited to auditing those returns solely for 8621 issues.
In 2013, the IRS initiated a new rule requiring individuals with foreign mutual funds to file Form 8621 even if there was no excess distribution.
**Under the new rule guidelines, if you owned foreign mutual funds pre-2013 and did not file an 8621 prior (and did not have any excess distributions during those years), you are not required to go back and file it for years prior to 2013.
Exceptions to Filing Form 8621
Finally, there are a few exceptions to having to file Form 8621 – namely if the total annual aggregate ownership of your PFIC investments is under $25,000 if you are single or married filing separate or $50,000 if you are married filing jointly, you do not have to file Form 8621.
But, keep in mind that this is for “annual aggregate ownership.” Thus, for example, if you have 10 PFICs each worth $20,000, you still have to file Form 8621 for each PFIC. If you have 10 PFICs each worth $1,000, then you do not have to file Form 8621.
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