PFIC Taxation – IRS Tax Basics of Passive Foreign Investments
When it comes to investing overseas in foreign investments, especially passive investments, it is important to research the investment carefully. That is because if the IRS believes your investment is a PFIC (Passive Foreign Investment Company) then there may be significant U.S. tax consequences.
Common PFIC Questions we receive:
- What is a PFIC?
- How do I know if I have a PFIC?
- Is a PFIC bad?
- What Can do to reduce PFIC Tax?
- Is there a way to avoid Excess Distributions?
There are numerous complexities involving the PFIC – mainly due to the increased tax liability for individuals who do not make a timely MTM or QEF election.
As a result, when there are distributions deemed to be Excess Distributions, the owner of the PFIC becomes subject to an exceedingly high Tax Liability at Ordinary Income tax rates – and amounts to a penalty tax.
Therefore, it is very important to stay in compliance with PFIC Reporting Requirements, including PFIC Investments, such as Foreign Mutual Funds
You May Have a PFIC and Not Know It
A PFIC is an acronym for the term Passive Foreign Investment Company. There are many common types of Passive Investment Companies abroad such as a BVI Limited or other personal holding or shell company used primarily to hold passive assets such as income generating investments (rental properties, dividends, Interest ) etc.
But, to make life utterly confusing, the IRS has expanded definition so that it typically will include items such as foreign mutual funds. In addition, other funds such as ETF and/or Equity Funds may also fall the PFIC Category.
Your Foreign Mutual Funds are Probably a PFIC
The reason we emphasize the Foreign Mutual Fund as a PFIC because it is not a commonly known or understood item to be characterized/classified as a PFIC. In other words, when somebody creates a holding company and proactively places various passive income investments into the holding company, they made a proactive step in forming a company – and therefore reporting comes as no big surprise.
Conversely, it is a big leap to impose such stringent reporting requirements and tax liability on an individual who may have simply invested in a foreign mutual fund at the behest of their advisor, family member or friend.
Certain Tax Elections May Reduce Your Tax Liability
There are certain ways to avoid the significant fines and penalties and individual faces when they hold onto an undisclosed PFIC, and then receive what is called an excess distribution. Unfortunately, one of the elections QEF is very difficult if not for the mere fact that it requires cooperation between your foreign investment fund and the IRS — typically, foreign investment funds do not willingly engage the IRS anymore than they have to.
Alternatively, the MTM election can be very beneficial, but late elections are rarely allowed unless a person submits to a full-blown OVDP (as of July 2017 streamlined submissions do not allow for the MTM election).
…But You Probably Never Made an Election
The election must be made proactively on a form 8621. If you did not know you had a PFIC, you probably never filed this form or updated your tax preparer that you have a PFIC (and many preparers, CPAs and tax attorneys have never heard the form, or what a PFIC is)
What is a QEF Election?
A Qualified Electing Fund or (QEF) Status is one method for US investors of PFICs to try and limit punitive nature of the US tax regime on PFIC investments. By making a QEF election (which is very strict requirements and time limitations) it allows the foreign PFIC to be treated as a U.S. investment for IRS tax purposes. As a result, capital gains are taxed at the capital gain rate, while income is taxed at the income tax rate – as opposed to a PFIC where all “earnings” are taxed at the highest tax bracket.
The biggest hurdle in achieving a QEF election is that the foreign fund is now going to have to meet IRS tax reporting requirements. For the most part, the reason why US investors invest in a PFIC is to avoid this type of reporting requirement. Moreover, most foreign fund managers are not going to want to take the time and effort to ensure compliance with IRS requirements – especially now that FATCA has begun enforcement.
*Overall, the QEF status is generally better than a MTM (market-to-market election – which requires recognition on the annual increase or decrease in market value as ordinary income or loss, with losses being limited) or excess distribution regime. The QEF election is made on form 8621.
**The failure to having reported the PFIC on your FBAR may lead to significant tax consequences, fines and penalties. If you own a PFIC and have not properly reported or disclosed your foreign earnings, you should consider entering one of the approved IRS Offshore Voluntary Disclosure programs.
What is an MTM Election?
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.
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.
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.
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?
First Distribution vs. Distribution in 1st Year of Investment?
If you receive a distribution in the first year of your investment, it is typically never an “Excess” distribution, since there is nothing for it to be in “excess” of. This is different than receiving a “First Distribution” many years after the initial investment.
No Election, and No Distribution?
While if you do not make an election, you will not tax until you begin receiving distributions, it is important to understand that your first distribution will most likely be an excess distributions the prior-year distributions will be zero.
Thus, when you are finally receiving distributions the tax liability case, including having all of the money that is distributed tax at the highest ordinary income tax-free available during each year you held the investment, calculated per day – with interest.
The current year you are taxed at your own ordinary income rate. In other words, even if you receive long-term capital gain qualified dividends it will still be taxed at the ordinary action.
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.
IRS Offshore Disclosure
If you have not reported any of your PFICs — probably also means you never filed an FBAR in those years, you may consider entering the IRS offshore voluntary disclosure program to try to get back into compliance before it is too late.
IRS Voluntary Disclosure of Offshore Accounts
IRS Voluntary Disclosure of Foreign or Offshore Accounts is a legal method for getting into IRS Tax and Reporting compliance before the IRS finds you first. At Golding & Golding, we limit our entire tax law practice to IRS Offshore Voluntary Disclosure.
Why IRS Voluntary Disclosure?
With the introduction and enforcement of FATCA (Foreign Account Tax Compliance Act) and FATCA penalties, coupled by the renewed interest in the IRS issuing FBAR (Report of Foreign Bank and Financial Account Form aka FinCEN 114) penalties — which are both very steep – it is typically a better strategy to be proactive and get into compliance, than to play “defense.”
FBAR penalties alone can reach ~$12,500 per account, per year (adjusted inflation from $10,000). While this is the maximum penalty, the “recommended penalty” is still $12,500 per year (usually 3-6 years).
4 Types of IRS Offshore Voluntary Disclosure Programs
There are typically four types of IRS Offshore Voluntary Disclosure programs, and they include:
- Offshore Voluntary Disclosure Program (OVDP)
- Streamlined Domestic Offshore Procedures (SDOP)
- Streamlined Foreign Offshore Procedures (SFOP)
- Reasonable Cause (RC)
IRS Voluntary Disclosure of Offshore Accounts
Offshore Voluntary Disclosure Tax law is very complex. There are many aspects that go into any particular tax calculation, including the legal status, marital status, business status and residence status of the taxpayer.
When Do I Need to Use Voluntary Disclosure?
Voluntary Disclosure is for individuals, estates, and businesses who are out of compliance with the IRS and the Department of Treasury. What does that mean? It means that for one or more years, you were required to file a U.S. tax return, FBAR or other International Informational Return and you did not do so timely, then you are out of compliance.
Common Un-filed IRS International Tax Forms
Common un-filed international tax forms, include:
- 1040 (Tax Returns)
- Schedule B (Ownership or Signature Authority over Foreign Accounts)
- FBAR (FinCEN 114)
- FATCA (Form 8938)
- Form 3520 (Gift from Foreign Person)
- Form 5471 (Foreign Corporations)
- Form 8621 (Foreign Investments, aka PFIC)
- Form 8865 (Foreign Partnership)
If the IRS discovers that you are out of compliance, you may become subject to extensive fines and penalties – ranging from a warning letter all the way up to tax liens, tax levies, seizures, and criminal investigations. To combat this, you can take the proactive approach and submit to IRS Offshore Voluntary Disclosure.
Golding & Golding – Offshore Disclosure
At Golding & Golding, we limit our entire practice to offshore disclosure (IRS Voluntary Disclosure of Foreign and U.S. Assets). The term offshore disclosure is a bit of a misnomer, because the term “offshore” generally connotes visions of hiding money in secret places such as the Cayman Islands, Bahamas, Malta, or any other well-known tax haven jurisdiction – but that is not the case.
In fact, any money that is outside of the United States is considered to be offshore; the term offshore is not a bad word. In other words, merely because a person has money offshore (a.k.a. overseas or in a foreign country) does not mean that money is the result of ill-gotten gains or that the money is being “hidden.”
It just means it is not in the United States. Many of our clients have assets and bank accounts in their homeland countries and these are considered offshore assets and offshore bank accounts.
The Devil is in the Details…
If you do have money offshore, then it is very important to ensure that the money has been properly reported to the U.S. government. In addition, it is also very important to ensure that if you are earning any foreign income from that offshore money, that the earnings are being reported on your U.S. tax return.
It does not matter whether your money is in a country that does not tax a particular category of income (for example, many Asian countries do not tax passive income). It also does not matter if you are a dual citizen and/or if that money has already been taxed in the foreign country.
Rather, the default position is that if you are required to file a U.S. tax return and you meet the minimum threshold requirements for filing a U.S. tax return, then you have to include all of your foreign income. If you already paid foreign tax on the income, you may qualify for a Foreign Tax Credit. In addition, if the income is earned income – as opposed to passive income – and you meet either the Bona-Fide Resident Test or Physical-Presence Test, then you may qualify for an exclusion of that income; nevertheless, the money must be included on your tax return.
What if You Never Report the Money?
If you are in the unfortunate position of having foreign money or specified foreign assets that should have been reported to the U.S. government, but which you have not reported — then you are in a bit of a predicament, which you will need to resolve before it is too late.
As we have indicated numerous times on our website, there are very unscrupulous CPAs, Attorneys, Accountants, and Tax Representatives who would like nothing more than to get you to part with all of your money by scaring you into believing you are automatically going to be arrested, jailed, or deported because you have unreported money. While that is most likely not the case (depending on the facts and circumstances of your specific situation), you may be subject to extremely high fines and penalties.
Moreover, if you knowingly or willfully hid your foreign accounts, foreign money, and offshore assets overseas, then you may become subject to even higher fines and penalties…as well as a criminal investigation by the special agents of the IRS and/or DOJ (Department of Justice).
Getting into Compliance
There are five main methods people/businesses use to get into compliance. Four of these methods are perfectly legitimate as long as you meet the requirements for the particular mechanism of disclosure. The fifth alternative, which is called a Quiet Disclosure a.k.a. Silent Disclosure a.k.a. Soft Disclosure, is ill-advised as it is illegal and very well may result in criminal prosecution.
5 IRS Methods for Offshore Compliance
- Streamlined Domestic Offshore Procedures
- Streamlined Foreign Offshore Procedures
- Reasonable Cause
- Quiet Disclosure (Illegal)
We are going to provide a brief summary of each program below. We have also included links to the specific programs. If you are interested, we have also prepared very popular “FAQs from the Trenches” for FBAR, OVDP and Streamlined Disclosure reporting. Unlike the technical jargon of the IRS FAQs, our FAQs are based on the hundreds of different types of issues we have handled over the many years that we have been practicing international tax law and offshore disclosure in particular.
After reading this webpage, we hope you develop a basic understanding of each offshore disclosure alternative and how it may benefit you to get into compliance. We do not recommend attempting to disclose the information yourself as you may become subject to an IRS investigation insofar as you will have to answer questions directly to the IRS, which you can avoid with an attorney representative.
If you retain an attorney, then you will get the benefit of the attorney-client privilege which provides confidentiality between you and your representative. With a CPA, there is a relatively small privilege which does provide some comfort, but the privilege is nowhere near as strong as the confidentiality privilege you enjoy with an attorney.
Since you will be dealing with the Internal Revenue Service and they are not known to play nice or fair – it is in your best interest to obtain an experienced Offshore Disclosure Attorney.
OVDP is the Offshore Voluntary Disclosure Program — a program designed to facilitate taxpayer compliance with IRS, DOT, and DOJ International Tax Reporting and Compliance. It is generally reserved for individuals and businesses who were “Willful” (aka intentional) in their failure to comply with U.S. Government Laws and Regulations.
The Offshore Voluntary Disclosure Program is open to any US taxpayer who has offshore and foreign accounts and has not reported the financial information to the Internal Revenue Service (restrictions apply). There are some basic program requirements, with the main one being that the person/business who is applying under this amnesty program is not currently under IRS examination.
The reason is simple: OVDP is a voluntary program and if you are only entering because you are already under IRS examination, then technically, you are not voluntarily entering the program – rather, you are doing so under duress.
Any account that would have to be included on either the FBAR or 8938 form as well as additional income generating assets such as rental properties are accounts that qualify under OVDP. It should be noted that the requirements are different for the modified streamlined program, in which the taxpayer penalties are limited to only assets that are actually listed on either an FBAR or 8938 form; thus the value of a rental property would not be calculated into the penalty amount in a streamlined application, but it would be applicable in an OVDP submission.
An OVDP submission involves the failure of a taxpayer(s) to report foreign and overseas accounts such as: Foreign Bank Accounts, Foreign Financial Accounts, Foreign Retirement Accounts, Foreign Trading Accounts, Foreign Insurance, and Foreign Income, including 8938s, FBAR, Schedule B, 5741, 3520, and more.
What is Included in the Full OVDP Submission?
The full OVDP application includes:
- Eight (8) years of Amended Tax Return filings;
- Eight (8) Years of FBAR (Foreign Bank and Account Reporting Statements);
- Penalty Computation Worksheet; and
- Various OVDP specific documents in support of the application.
Under this program, the Internal Revenue Service wants to know all of the income that was generated under these accounts that were not properly reported previously. The way the taxpayer accomplishes this is by amending tax returns for eight years.
Generally, if the taxpayer has not previously reported his accounts, then there are common forms which were probably excluded from the prior year’s tax returns and include 8938 Forms, Schedule B forms, 3520 Forms, 5471 Forms, 8621 Forms, as well as proof of filing of FBARs (Foreign Bank and Financial Account Reports).
The taxpayer is required to pay the outstanding tax liability for the eight years within the disclosure period – as well as payment of interest along with another 20% penalty on that amount (for nonpayment of tax). To give you an example, let’s pick one tax year during the compliance period. If the taxpayer owed $20,000 in taxes for year 2014, then they would also have to include in the check the amount of $4,000 to cover the 20% penalty, as well as estimated interest (which is generally averaged at about 3% per year). This must be done for each year during the compliance period.
Then there is the “FBAR/8938” Penalty. The Penalty is 27.5% (or 50% if any of the foreign accounts are held at an IRS “Bad Bank”) on the highest year’s “annual aggregate total” of unreported accounts (accounts which were previously reported are not calculated into the penalty amount).
For OVDP, the annual aggregate total is determined by adding the “maximum value” of each unreported account for each year, in each of the last 8 years. To determine what the maximum value is, the taxpayer will add up the highest balances of all of their accounts for each year. In other words, for each tax year within the compliance period, the application will locate the highest balance for each account for each year, and total up the values to determine the maximum value for each year.
Thereafter, the OVDP applicant selects the highest year’s value, and multiplies it by either 27.5%, or possibly 50% if any of the money was being held in what the IRS considers to be one of the “bad banks.” When a person is completing the penalty portion of the application, the two most important things are to breathe and remember that by entering the program, the applicant is seeking to avoid criminal prosecution!
2. Streamlined Domestic Offshore Disclosure
The Streamlined Domestic Offshore Disclosure Program is a highly cost-effective method of quickly getting you into IRS (Internal Revenue Service) or DOT (Department of Treasury) compliance.
What am I supposed to Report?
There are three main reporting aspects: (1) foreign account(s), (2) certain specified assets, and (3) foreign money. While the IRS or DOJ will most likely not be kicking in your door and arresting you on the spot for failing to report, there are significantly high penalties associated with failing to comply.
In fact, the US government has the right to penalize you upwards of $10,000 per unreported account, per year for a six-year period if you are non-willful. If you are determined to be willful, the penalties can reach 100% value of the foreign accounts, including many other fines and penalties… not the least being a criminal investigation.
Reporting Specified Foreign Assets – FATCA Form 8938
Not all foreign assets must be reported. With that said, a majority of assets do have to be reported on a form 8938. For example, if you have ownership of a foreign business interest or investment such as a limited liability share of a foreign corporation, it may not need to be reported on the FBAR but may need to be disclosed on an 8938.
The reason why you may get caught in the middle of whether it must be filed or not is due largely to the reporting thresholds of the 8938. For example, while the threshold requirements for the FBAR is when the foreign accounts exceed $10,000 in annual aggregate total – and is not impacted by marital status and country of residence – the same is not true of the 8938.
The threshold requirements for filing the 8938 will depend on whether you are married filing jointly or married filing separate/single, or whether you are considered a US resident or foreign resident.
Other Forms – Foreign Business
While the FBAR and Form 8938 are the two most common forms, please keep in mind that there are many other forms that may need to be filed based on your specific facts and circumstances. For example:
- If you are the Beneficiary of a foreign trust or receive a foreign gift, you may have to file Form 3520.
- If you are the Owner of a foreign trust, you will also have to file Form 3520-A.
- If you have certain Ownerships of a foreign corporation, you have to file Form 5471.
- And (regrettably) if you fall into the unfortunate category of owning foreign mutual funds or any other Passive Foreign Investment Companies then you will have to file Form 8621 and possibly be subject to significant tax liabilities in accordance with excess distributions.
Reporting Foreign Income
If you are considered a US tax resident (which normally means you are a US citizen, Legal Permanent Resident/Green-Card Holder or Foreign National subject to US tax under the substantial presence test), then you will be taxed on your worldwide Income.
It does not matter if you earned the money in a foreign country or if it is the type of income that is not taxed in the country of origin such as interest income in Asian countries. The fact of the matter is you are required to report this information on your US tax return and pay any differential in tax that might be due.
In other words, if you earn $100,000 USD in Japan and paid 25% tax ($25,000) in Japan, you would receive a $25,000 tax credit against your foreign earnings. Thus, if your US tax liability is less than $25,000, then you will receive a carryover to use in future years against foreign income (you do not get a refund and it cannot be used against US income). If you have to pay the exact same in the United States as you did in Japan, it would equal itself out. If you would owe more money in the United States than you paid in Japan on the earnings (a.k.a. you are in a higher tax bracket), then you have to pay the difference to the U.S. Government.
3. Streamlined Foreign Offshore Disclosure
What do you do if you reside outside of the United States and recently learned that you’re out of US tax compliance, have no idea what FATCA or FBAR means, and are under the misimpression that you are going to be arrested and hauled off to jail due to irresponsible blogging by inexperienced attorneys and accountants?
If you live overseas and qualify as a foreign resident (reside outside of the United States for at least 330 days in any one of the last three tax years or do not meet the Substantial Presence Test), you may be in for a pleasant surprise.
Even though you may be completely out of US tax and reporting compliance, you may qualify for a penalty waiver and ALL of your disclosure penalties would be waived. Thus, all you will have to do besides reporting and disclosing the information is pay any outstanding tax liability and interest, if any is due. (Your foreign tax credit may offset any US taxes and you may end up with zero penalty and zero tax liability.)
*Under the Streamlined Foreign, you also have to amend or file 3 years of tax returns (and 8938s if applicable) as well as 6 years of FBAR statements just as in the Streamlined Domestic program.
4. Reasonable Cause
Reasonable Cause is different than the above referenced programs. Reasonable Cause is not a “program.” Rather, it is an alternative to traditional Offshore Voluntary Disclosure, which should be considered on a case by case basis, taking the specific facts and circumstances into consideration.