In previous blogs, we’ve discussed some of the basics of PFIC ownership, including PFIC reporting, PFIC elections, and whether gifts are subject to the PFIC rules.
We’ve touched on the notion that onerous implications arise from selling or distributing from PFICs (absent a QEF or MTM election), but haven’t yet spelled out how the PFIC tax works. In this blog, we dive into the PFIC tax itself, and explain how it functions as a powerful anti-deferral tool for the IRS.
Excess and Nonexcess Distributions
In general, the taxation of a PFIC distribution depends on the distribution amount as compared to the PFIC’s distributions in prior years.
Distributions from a PFIC fall into two categories, “excess” distributions and “nonexcess” distributions. An excess distribution is the portion of a distribution from a PFIC that exceeds 125% of the average distributions made to the shareholder with respect to the shareholder’s shares within the three preceding years included in the shareholder’s holding period or, if the shareholder’s holding period is less than three years, the shareholder’s actual holding period. A nonexcess distribution is the part of a distribution that is not an excess distribution.
It’s important to note that a sale (or other disposition, including a gift) of PFIC shares is treated as an excess distribution to the extent the proceeds of sale exceed the seller’s basis in the PFIC shares.
Taxing PFIC Distributions
The portion of a PFIC distribution that is a nonexcess distribution is taxed to the shareholder based on the general rules of U.S. corporate income taxation, which results in dividend treatment to the extent of current or accumulated earnings and profits (E&P).
However, it should be noted that a nonexcess distribution from a PFIC will not qualify for beneficial long-term rates (generally, 15-20%), because a PFIC by definition is not a “qualified foreign corporation” and therefore distributions from a PFIC do not qualify as “qualified dividend income.”
For excess distributions, the steps are as follows: The taxpayer must first allocate the distribution pro rata to each day in the shareholder’s holding period for the shares. Next, the portion of the excess distribution allocated to the current year and the pre-PFIC years is included in the taxpayer’s income for the year of receipt as ordinary income. The portion of the excess distribution allocated to other years in the taxpayer’s holding period (the “PFIC years”) is not included in the shareholder’s income. Rather, this portion is subject to a special “deferred tax” that the taxpayer must add to her tax that otherwise is due.
The PFIC Deferred Tax
This is where the onerous aspect of PFIC taxation comes in - to compute the deferred tax, the shareholder must first multiply the distribution allocated to each PFIC year by the top marginal tax rate in effect for that year. The shareholder then aggregates all the “unpaid” tax amounts for the PFIC years. The shareholder must then compute interest on those increased tax amounts as if he had not paid the tax for the PFIC years when due using the applicable federal underpayment rate. The taxpayer includes the deferred tax and interest as separate line items on her individual income tax return.
The effect of the deferred tax and the interest charge is to prevent anti-deferral abuse, since the tax eventually charged ends up neutralizing the benefits of deferring tax until a distribution is made from the PFIC. For this reason, U.S. expats should carefully consider investments treated as PFICs (particularly those for which a QEF or MTM election is not available), as the adverse tax implications can greatly affect the overall value of the investments.
