PFICs: Why Identifying Foreign Investments Early Matters

Understanding PFIC investments and their tax implications can help investors avoid unexpected tax consequences

Foreign investments can create U.S. tax consequences that are easy to overlook. One area that deserves particular attention is the Passive Foreign Investment Company, or PFIC, rules. A PFIC is a special U.S. tax classification for certain foreign corporations that primarily earn passive income or hold passive investment assets under IRC §1297.

PFIC exposure is not limited to investments that appear unusual or particularly “foreign.” A U.S. investor can own a PFIC directly or indirectly, and PFIC exposure can arise through alternative investment structures and pass-through entities. IRS Form 8621 – Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, may therefore be required for both direct and indirect PFIC ownership.

How a Timely QEF Election Can Affect PFIC Investments

Consider an example: A partnership or an individual invests $100,000 in a PFIC and five years later it is worth $200,000.

If the PFIC is identified in the first year and a Qualified Electing Fund, or QEF, election is timely made, the investor reports his or her share of the fund’s ordinary earnings and net capital gain each year in a way that is similar to a flow through investment. The investor is then generally outside the punitive §1291 excess-distribution regime for that investment, and upon sale, the gain in the investment is generally treated as long-term capital gain. Further, you increase your basis in the investment for any ordinary income or capital gains reported on the investment.

What Happens When a QEF Election Is Not Made?

Now consider the same $100,000 investment when no QEF is made.

If the investment grows to $200,000 and is sold, the $100,000 gain can become subject to the §1291 rules. Rather than simply treating the entire gain as a long-term capital gain in the year of sale, the PFIC rules treat the gain as ordinary income that is apportioned over the investor’s holding period. As stated above, the gain is subject to ordinary income tax rates using the highest applicable rate for those years.

In our five-year example, a portion of the gain would be apportioned to each year of the holding period. The tax attributable to Year 1 is treated as deferred tax, same with the tax attributable to Year 2, and so on. Because the tax is not actually paid until the investment is sold in Year 5, an interest charge is imposed on the deferred tax attributable to those prior years. The longer the PFIC is held, the more significant that interest-charge can become.

This is what makes identification of the PFIC in the year of investment so important. Two investors can make the same $100,000 investment, experience the same growth to $200,000, and face materially different tax results simply because one identified the PFIC and made a timely QEF election while the other did not.

What If a PFIC investment was not identified early?

What if the PFIC was not identified in the year of investment and no QEF Election was made? All may not be lost.

An investor who later discovers a PFIC investment can make the QEF election but also must purge or cleanse the unrealized gain through the election date. The deemed-sale election under §1291(d)(2) is not free. The stock is treated as sold at fair market value on the qualification date (the first day of the first QEF year). That gain is taxed as an excess distribution, meaning ordinary income plus interest, and losses on the deemed sale are not recognized.

Could you have PFIC exposure?

PFICs can be held directly or indirectly, including through alternative investment structures. If you hold foreign investments, foreign funds, or receive foreign investment exposure through a K-1 or similar structure, it is worth asking whether PFIC reporting is part of the picture.

Keiter’s Tax Professionals can help identify potential PFIC exposure, explain the tax impact of the available elections, and evaluate options when a PFIC was not identified at the time of the original investment. Contact your Keiter Opportunity Advisor | Email | Call 804.477.0000 to learn more.