- 1 PFIC – Common Questions & Answers
- 2 Passive Foreign Investment Company (More Detailed PFIC Summary)
- 3 PFIC
- 4 What is a PFIC?
- 5 You May Have a PFIC and Not Know It
- 6 Your Foreign Mutual Funds are Probably a PFIC
- 7 Certain Tax Elections May Reduce Your Tax Liability
- 8 …But You Probably Never Made an Election
- 9 What is a QEF Election?
- 10 What is an MTM Election?
- 11 What is an Excess Distribution?
- 12 First Distribution vs. Distribution in 1st Year of Investment?
- 13 No Election, and No Distribution?
- 14 PFIC Penalties
- 15 IRS Voluntary Disclosure
- 16 We Specialize in Safely Disclosing Foreign Money
- 17 Who Decides to Disclose Unreported Money?
- 18 IRS Penalty List
- 19 What Should You Do?
- 20 Be Careful of the IRS
- 21 4 Types of IRS Voluntary Disclosure Programs
PFIC in 2019 – Summarizing PFIC Common Questions & Answers
PFIC – Common Questions & Answers
What is a PFIC?
A PFIC is a Passive Foreign Investment Company, as defined by the Internal Revenue Code.
What is a Section 1291 Fund?
A Section 1291 Fund is a PFIC (Passive Foreign Investment Company) and it receives different tax treatment than other foreign passive investments.
How is a PFIC Taxed?
It depends on whether:
- It is an Excess Distribution
- It is a Non-Excess Distribution
- An MTM or QEF election was made
How is Excess PFIC Calculated?
The calculation for an Excess Distribution is very detailed, and has multiple steps.
Is a Foreign Mutual Fund a PFIC?
Yes, since since it will almost always meet the 50% asset test or 75% income test under 1291 et seq.
Do you Pay Tax on Foreign Mutual Funds?
Yes. But, since most Foreign Mutual Funds are considered PFIC, the tax analysis is much complex (and complicated).
Are ETFs PFICs?
Yes, generally they will also be considered PFIC, since they generally function in the same vein as Mutual Funds.
Can you be a PFIC and CFC?
Yes. But, you may be limited in having to report both, and you may be able to avoid duplicate reporting (generally, the CFC status reporting trumps PFIC reporting)
What is a PFIC Election?
In order to reduce taxes on PFIC, you may be able to make an election. The two elections are QEF (Qualified Electing Fund) and MTM (Mark-to-Market)
Passive Foreign Investment Company (More Detailed PFIC Summary)
PFIC (Passive Foreign Investment Company IRS Tax Rules are complex, . The Internal Revenue Service has made the enforcement of Taxation of Foreign Passive Investments a key priority.
The (IRS) has made it nearly impossible for U.S. Taxpayers to figure out how the taxation of how PFIC (Passive Foreign Investments works).
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?
A PFIC is a Passive Foreign Investment Company. The IRS (Internal Revenue Service) rules for evaluating and analyzing the tax implications of a PFIC are very complex.
When it comes to U.S. Persons investing in foreign, offshore and other passive investments abroad — it is very important to research the investment carefully.
That is because if the IRS believes you are a U.S. Shareholder with an investment is a PFIC (Passive Foreign Investment Company) then there may be significant U.S. tax consequences.
What is a PFIC?
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 Voluntary 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.
We Specialize in Safely Disclosing Foreign Money
We have successfully handled a diverse range of IRS Voluntary Disclosure and International Tax Investigation/Examination cases involving FBAR, FATCA, and high-stakes matters for clients around the globe (In over 65 countries!)
Whether it is a simple or complex case, safely getting clients into compliance is our passion, and we take it very seriously.
Who Decides to Disclose Unreported Money?
What Types of Clients Do we Represent?
We represent Attorneys, CPAs, Doctors, Investors, Engineers, Business Owners, Entrepreneurs, Professors, Athletes, Actors, Entry-Level staff, Students, Former/Current IRS Agents and more.
You are not alone, and you are not the only one to find himself or herself in this situation.
Sean M. Golding, JD, LL.M., EA – Board Certified Tax Law Specialist
Our Managing Partner, Sean M. Golding, JD, LLM, EA holds an LL.M. (Master’s in Tax Law) from the University of Denver and is also an Enrolled Agent (the highest credential awarded by the IRS, and authorizes him to represent clients nationwide.)
He is frequently called upon to lecture and write on issues involving IRS Voluntary Disclosure.
Less than 1% of Tax Attorneys Nationwide
Out of more than 200,000 practicing attorneys in California, less than 400 attorneys have achieved this Certified Tax Law Specialist designation.
The exam is widely regarded as one of (if not) the hardest tax exam given in the United States for practicing Attorneys. It is a designation earned by less than 1% of attorneys.
IRS Penalty List
The following is a list of potential IRS penalties for unreported and undisclosed foreign accounts and assets:
Failure to File
If you do not file by the deadline, you might face a failure-to-file penalty. If you do not pay by the due date, you could face a failure-to-pay penalty. The failure-to-file penalty is generally more than the failure-to-pay penalty.
The penalty for filing late is usually 5 percent of the unpaid taxes for each month or part of a month that a return is late. This penalty will not exceed 25 percent of your unpaid taxes. If you file your return more than 60 days after the due date or extended due date, the minimum penalty is the smaller of $135 or 100 percent of the unpaid tax.
Failure to Pay
f you do not pay your taxes by the due date, you will generally have to pay a failure-to-pay penalty of ½ of 1 percent of your unpaid taxes for each month or part of a month after the due date that the taxes are not paid. This penalty can be as much as 25 percent of your unpaid taxes. If both the failure-to-file penalty and the failure-to-pay penalty apply in any month, the 5 percent failure-to-file penalty is reduced by the failure-to-pay penalty.
However, if you file your return more than 60 days after the due date or extended due date, the minimum penalty is the smaller of $135 or 100 percent of the unpaid tax. You will not have to pay a failure-to-file or failure-to-pay penalty if you can show that you failed to file or pay on time because of reasonable cause and not because of willful neglect.
Civil Tax Fraud
If any part of any underpayment of tax required to be shown on a return is due to fraud, there shall be added to the tax an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud.
A Penalty for failing to file FBARs
The civil penalty for willfully failing to file an FBAR can be as high as the greater of $100,000 or 50 percent of the total balance of the foreign financial account per violation. See 31 U.S.C. § 5321(a)(5). Non-willful violations that the IRS determines were not due to reasonable cause are subject to a $10,000 penalty per violation.
A Penalty for failing to file Form 8938
The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.
A Penalty for failing to file Form 3520
The penalty for failing to file each one of these information returns, or for filing an incomplete return, is the greater of $10,000 or 35 percent of the gross reportable amount, except for returns reporting gifts, where the penalty is five percent of the gift per month, up to a maximum penalty of 25 percent of the gift.
A Penalty for failing to file Form 3520-A
The penalty for failing to file each one of these information returns or for filing an incomplete return, is the greater of $10,000 or 5 percent of the gross value of trust assets determined to be owned by the United States person.
A Penalty for failing to file Form 5471
A Penalty for failing to file Form 5472
The penalty for failing to file each one of these information returns, or to keep certain records regarding reportable transactions, is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency.
A Penalty for failing to file Form 926
The penalty for failing to file each one of these information returns is ten percent of the value of the property transferred, up to a maximum of $100,000 per return, with no limit if the failure to report the transfer was intentional.
A Penalty for failing to file Form 8865
Penalties include $10,000 for failure to file each return, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return, and ten percent of the value of any transferred property that is not reported, subject to a $100,000 limit.
Fraud penalties imposed under IRC §§ 6651(f) or 6663
Where an underpayment of tax, or a failure to file a tax return, is due to fraud, the taxpayer is liable for penalties that, although calculated differently, essentially amount to 75 percent of the unpaid tax.
A Penalty for failing to file a tax return imposed under IRC § 6651(a)(1)
Generally, taxpayers are required to file income tax returns. If a taxpayer fails to do so, a penalty of 5 percent of the balance due, plus an additional 5 percent for each month or fraction thereof during which the failure continues may be imposed. The penalty shall not exceed 25 percent.
A Penalty for failing to pay the amount of tax shown on the return under IRC § 6651(a)(2)
If a taxpayer fails to pay the amount of tax shown on the return, he or she may be liable for a penalty of .5 percent of the amount of tax shown on the return, plus an additional .5 percent for each additional month or fraction thereof that the amount remains unpaid, not exceeding 25 percent.
An Accuracy-Related Penalty on underpayments imposed under IRC § 6662
Depending upon which component of the accuracy-related penalty is applicable, a taxpayer may be liable for a 20 percent or 40 percent penalty
Possible Criminal Charges related to tax matters include tax evasion (IRC § 7201)
Filing a false return (IRC § 7206(1)) and failure to file an income tax return (IRC § 7203). Willfully failing to file an FBAR and willfully filing a false FBAR are both violations that are subject to criminal penalties under 31 U.S.C. § 5322. Additional possible criminal charges include conspiracy to defraud the government with respect to claims (18 U.S.C. § 286) and conspiracy to commit offense or to defraud the United States (18 U.S.C. § 371).
A person convicted of tax evasion
Filing a false return subjects a person to a prison term of up to three years and a fine of up to $250,000. A person who fails to file a tax return is subject to a prison term of up to one year and a fine of up to $100,000. Failing to file an FBAR subjects a person to a prison term of up to ten years and criminal penalties of up to $500,000. A person convicted of conspiracy to defraud the government with respect to claims is subject to a prison term of up to not more than 10 years or a fine of up to $250,000. A person convicted of conspiracy to commit offense or to defraud the United States is subject to a prison term of not more than five years and a fine of up to $250,000.
What Should You Do?
Everyone makes mistakes. If at some point that you should have been reporting your foreign income, accounts, assets or investments the prudent and least costly (but most effective) method for getting compliance is through one of the approved IRS offshore voluntary disclosure program.
Be Careful of the IRS
With the introduction and enforcement of FATCA for both Civil and Criminal Penalties, renewed interest in the IRS issuing FBAR Penalties, crackdown on Cryptocurrency (and IRS joining J5), the termination of OVDP, and recent foreign bank settlements with the IRS…there are not many places left to hide.
4 Types of IRS Voluntary Disclosure Programs
There are typically four types of IRS Voluntary Disclosure programs, and they include:
- Traditional (IRM) IRS Voluntary Disclosure Program
- Streamlined Domestic Offshore Procedures (SDOP)
- Streamlined Foreign Offshore Procedures (SFOP)
- Reasonable Cause (RC)
Contact Us Today; Let us Help You.
Sean holds a Master's in Tax Law from one of the top Tax LL.M. programs in the country at the University of Denver, and has also earned the prestigious Enrolled Agent credential. Mr. Golding is also a Board Certified Tax Law Specialist Attorney (A designation earned by Less than 1% of Attorneys nationwide.)
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