Should You Make a Late MTM (PFIC) Election Post First Year?

Oftentimes, when U.S. taxpayers assess whether they should make an election for their PFIC (Passive Foreign Investment Company), the main type of election taxpayers opt for is the QEF election (Qualified Electing Fund). While in many scenarios the QEF election will net a greater tax benefit than an MTM election, not all taxpayers are eligible to make a QEF election, because not all investments qualify for the QEF election. That is because with the QEF election, the financial institution must be able to provide certain QEF information to the IRS when required — and some foreign investment companies simply will not provide that information to the investor.

Likewise, even if the investment company may provide that information many U.S. taxpayers do not want to request it because by doing so it may alert the fund to the fact that the investor is a U.S. person and ultimately it may result in the taxpayer being ousted from the foreign investment (since many foreign companies do not want to become subject to the onerous U.S. tax and reporting rules for investors in their scheme who are U.S. persons). Let’s take a brief look at how the MTM election works.

What are the MTM Requirements?

To be eligible to make an MTM election, it is important to note that the stock must be marketable in conjunction with section 1296 and the corresponding regulation.

Typically, this requires that the PFIC stock that is regularly traded (as defined in Regulations section 1.1296-2(b)) on:

- - 1. A national securities exchange that is registered with the Securities and Exchange Commission (SEC),
  - 2. The national market system established under section 11A of the Securities Exchange Act of 1934, or
  - 3. A foreign securities exchange that is regulated or supervised by a governmental authority of the country in which the market is located and has the characteristics described in Regulations section 1.1296-2(c)(1)(ii).
    - - Stock in certain PFICs described in Regulations section 1.1296-2(d).
      - For additional information, including special rules for regulated investment companies (RICs) that own PFIC stock, see Regulations section 1.1296-1 and 1.1296-2.”

In other words, the stock must be marketable; if the stock is not marketable, then it does not qualify for an MTM election.

How is a PFIC MTM Election Taxed?

Let’s briefly take a look at how a mark-to-market election impacts the taxation of a PFIC

As provided by the IRS:

- - After a PFIC shareholder elects to mark the stock to market under section 1296, the shareholder either:
    - Includes in income each year an amount equal to the excess, if any, of the fair market value of the PFIC stock as of the close of the tax year over the shareholder’s adjusted basis in such stock; or
    - Is allowed a deduction equal to the lesser of: a. The excess, if any, of the adjusted basis of the PFIC stock over its fair market value as of the close of the tax year; or b. The excess, if any, of the amount of mark-to-market gain included in the gross income of the PFIC shareholder for prior tax years over the amount allowed such PFIC shareholder as a deduction for a loss with respect to such stock for prior tax years.

- - See the instructions for Part II, Election C, and Part IV, later, for more information, including special rules that may apply in the year that a mark-to-market election is made. Basis adjustment. If the stock is held directly, the shareholder’s adjusted basis in the PFIC stock is increased by the amount included in income and decreased by any deductions allowed. If the stock is owned indirectly through foreign entities, see Regulations section 1.1296-1(d)(2).

Practice Tip

To recap the Form 8621 instructions above, essentially, with the MTM election, the taxpayer must pay tax on the growth in FMV of the stock. For example, if the taxpayers mark to market value at the end of the prior year was $2,000,000 and the current year was $2,100,000, then the taxpayer would pay tax on the 100,000. It is important to note that the taxpayer pays this tax even though the actual sale has not taken place, and at OI rates.

In addition, the taxpayer may be able to subtract losses, but only over prior gains. In other words, if the current year losses exceed the prior year gains, the taxpayer cannot take losses beyond what would reduce it back to its mark-to-market value and not lower.

Making a Late MTM Election

While making a retroactive election for MTM can be difficult due to the IRS requirements, taxpayers can typically make an election in a later year, although the excess distribution rules will apply.

26 USC 1296(j):

- - (j)Coordination with section 1291 for first year of election
    - (1) Taxpayers other than regulated investment companies
      - (A) In general
        
        If the taxpayer elects the application of this section with respect to any marketable stock in a corporation after the beginning of the taxpayer’s holding period in such stock, and if the requirements of subparagraph (B) are not satisfied, section 1291 shall apply to— (i) any distributions with respect to, or disposition of, such stock in the first taxable year of the taxpayer for which such election is made, and (ii)any amount which, but for section 1291, would have been included in gross income under subsection (a) with respect to such stock for such taxable year in the same manner as if such amount were gain on the disposition of such stock.
      - (B) Requirements The requirements of this subparagraph are met if, with respect to each of such corporation’s taxable years for which such corporation was a passive foreign investment company and which begin after December 31, 1986, and included any portion of the taxpayer’s holding period in such stock, such corporation was treated as a qualified electing fund under this part with respect to the taxpayer.

What does this mean?

It means that if the taxpayer did not make an MTM election in the first year (and did not previously make a QEF election), then in the first year of the election, they will be subject to the 1291 excess distribution calculation.

Per the IRS Instructions:

Coordination of Election C with section 1291 for first year of election.

- - In general, when a shareholder makes a mark?to?market election for PFIC stock in a year other than the first year in which the shareholder holds stock in the PFIC and no QEF election is in effect, the PFIC stock is treated as sold at fair market value on the last day of the tax year for which the election is made, and the gain is treated as an excess distribution subject to section 1291. In addition, any distributions made during the year with respect to the PFIC stock are subject to section 1291. See section 1296(j) and Regulations section 1.1296?1(i).

Per the CFR (Regulations):

26 CFR § 1.1296-1 – Mark to market election for marketable stock.

- - (i) Coordination rules for first year of election—
    - (2) Shareholders other than regulated investment companies.
      - For the first taxable year of a United States person (other than a regulated investment company) for which a section 1296 election is in effect with respect to the stock of a PFIC, such United States person shall, in lieu of the rules of paragraphs (c) and (d) of this section—
        
        (i) Apply the rules of section 1291 to any distributions with respect to, or disposition of, section 1296 stock;
        
        (ii) Apply section 1291 to the amount of the excess, if any, of the fair market value of such section 1296 stock on the last day of the United States person’s taxable year over its adjusted basis, as if such amount were gain recognized from the disposition of stock on the last day of the taxpayer’s taxable year; and
        
        (iii) Increase its adjusted basis in the section 1296 stock by the amount of excess, if any, subject to section 1291 under paragraph (i)(2)(ii) of this section.

Pros to the MTM Election

The benefits of the mark-to-market election are that the taxpayer does not have to pay excess distribution at the highest tax rate, but rather OI rates (which is a tangible benefit unless the taxpayer is in the highest tax bracket). In addition, the taxpayer may utilize losses to reduce the overall tax liability (although the amount of losses they can apply is limited)

Cons to the MTM Election

The biggest con is that the taxpayers pay tax on the annual income, even though the income may be distributed. So, for example, if the taxpayer were to pay income tax on $100,000 worth of gains at the ordinary income tax rates, he could be paying a significant amount of ta,x and depending on how speculative the asset is, the taxpayer may ultimately not receive any benefit from the investment in the future. Thus, the taxpayer paid income tax on income that he may never receive.

In addition, if the value of the asset is large and constitutes a large portion of the taxpayer’s net worth, then liquidity (in order to pay the annual tax) could potentially pose an issue.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties.

**Need Help Finding an Experienced Offshore Tax Attorney?**

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting.

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