A Form 8621 is an Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. It is an IRS Form required to be filed by individuals who have any interest in a Passive Foreign Investment Company — whether or not they received an Excess Distribution, as long as they are not otherwise exempt from filing.
How Are Foreign Investments Reported?
Unlike IRS Form 5471, there is no minimum ownership requirement. Technically, even if you have “fractional ownership,” of a PFIC you are still required to file — unless you meet one of the very limited exemptions/exclusions.
Moreover, the mere ownership of Foreign Mutual Funds and other foreign passive investments (that you do not technically own in a PFIC company) requires you to file the form.
What is a PFIC?
PFIC is a Passive Foreign Investment Company. It is a foreign investment which begins with tax deferred status, and then becomes tax headache, before becoming a tax nightmare — culminating with a huge tax bill.
PFIC Rules for Reporting
The form can be daunting, especially when the filer also has a tax liability in accordance with form 8621.
Under the updated PFIC Reporting Rules, individuals are required to file a Form 8621 simply to report their PFIC. This is true, even if the person has no tax liability. Previously, individuals would only have to file a Form 8621 if they had a tax liability/excess distribution.
Failure to File Form 8621
Notwithstanding Excess Distribution calculations, the “main non-numerical” penalty associated with form 8621 is completely unfair (you can read here about the sheer horror of the “Excess Distribution calculation“).
Why? Because technically, while there is no specific numerical penalty included regarding non-filing of Form 8621, a tax return is still considered to be “open” until the 8621 is filed. In other words, the statute of limitations countdown for the IRS to audit your tax return (usually 3 years) does not even begin to tick if the 8621 hasn’t been filed.
*Even if you try to argue the return only remains open as to the 8621, the IRS will most likely still take you to task as to the whole return. Even if you could convince the agent that a post-statute audit should be contained to 8621 issues, the IRS would just need to show some relation from the 8621, to other parts of your return, to continue with a more expansive audit.
Example of an Excess Distribution?
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 IRS 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:
PFIC Tax 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.
PFIC Tax 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)
PFIC Tax 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.
PFIC Tax 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.
PFIC Tax 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.
PFIC Tax 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.
PFIC Tax 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.
PFIC Tax 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).
PFIC Tax 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.
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.
General IRS Statute of Limitations
One of the most brutal aspects of failing to file Form 8621 is that such a failure to file suspends the statute of limitations. In other words, if a person fails to file form 8621, then the IRS can audit the entire return “forever” and would not otherwise be barred by the general statute of limitations.
Under ordinary circumstances, an individual can only be audited on the return for three years (presuming the return was filed timely – if no return was filed, the statue limitations does not even begin). The idea behind a Statute of Limitations is that it provides a form of closure for an individual to know that the tax return was filed and accepted by the IRS; it would be unfair to allow the IRS audit you “forever,” as documents and memories fade over time.
There are other circumstances in which the IRS can audit you for six years instead of three years (significant unreported income from U.S. or domestic sources) or no statute of limitations if the IRS can prove fraud. Fraud is a lot different than unknowingly not filing a Form 8621 because you never even heard of the form.
IRA Form 8621 IRS Tax & Reporting Compliance
It is crucial that if you were required to file form 8621, but did not do so that you get into compliance as quickly and safely as possible. One of the most effective methods of getting into compliance is to submit to IRS voluntary disclosure.
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