PFIC (2018) – Basics of IRS PFIC Taxes, Elections, & Penalties
A PFIC is a Passive Foreign Investment Company, which may need to be reported on IRS Form 8621. The PFIC Rules can be complex, and this article will help breakdown common PFIC questions.
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
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.