PFIC Overview: Form 8621 Tax Consequences

Before we dive in to the details of PFIC taxation and PFIC informational reporting, let me begin by saying, if you have PFICs, I’m sorry that you find yourself in this situation with one of the most tax disadvantaged types of investments for purposes of U.S. taxation. The effective tax rate applied to PFICs can theoretically exceed 100% of the gain from the sale, so unless your investment is outside of your control or performing well enough to compensate for the compliance and tax costs associated with that investment, I encourage you to consider selling your PFICs and investing in less disadvantaged investments. Ripping off the bandaid may be painful, but the longer you hold on to PFICs the higher the potential effective rate of tax becomes.

When you acquire a PFIC, you will likely have a few options in terms of how you want that to be treated (future article coming soon), but most people learn about the tax implications of PFIC ownership after they have owned the PFIC for several years, and wrongfully assumed that the taxation of their foreign mutual funds would be similar to the taxation of U.S. mutual funds or of share sales generally.

There are three separate tax regimes that can potentially be applied to PFIC investments. QEF, Mark to Market, and 1291(the default treatment). Unless you are a sophisticated investor who knew what he was getting involved in when acquiring your PFICs, QEF is likely not for you. Mark to Market is almost always a better treatment than the default treatment, but the problem is that in order to avoid the default treatment, you need to elect in to mark to market in the year of acquisition. With the default treatment, 1291, you will see yourself taxed upon sale at the highest marginal tax rate for each year the investment was held and interest will be applied as though the tax due for each year was due with the tax return for each year to which the income is allocated. 

1291 taxation sounds complicated…. and that is because it is. Let’s take a quick detour through a hypothetical to give a little clarity to the mechanics of 1291. If you purchased a foreign mutual fund on December 01, 2016 and sold all of your shares in that mutual fund on January 2nd, 2018, all of the tax for that sale will be added to your 2018 return, but the income from that sale is equally allocated to each day of your holding period (12/01/16 - 01/02/18) and the amounts allocated to 2016 and 2017 will be taxed at the highest marginal rates for those years (39.6% for both years) and interest be applied to the income allocated to 2016 (running from April 15th 2017, the due date of your 2016 return) and the income allocated to 2016 (running from April 15th 2018, the due date of your 2017 return). The amounts allocated to 2018, for January 1st and 2nd, will be included as ordinary income on your 2018 return and taxed at YOUR (not the highest as was the cas for prior years) marginal tax rate.

We have some more examples of 1291 taxation (Future article coming soon), mark to market PFIC taxation (future article coming soon) and QEF taxation (future article coming soon)

The last consideration worth detailing is that you can elect out of 1291 treatment but this election involves having a ‘deemed sale’ of all of your shares. This effectively means that you will subject your shares to the default 1291 treatment in the current year so that you can elect in to an alternative treatment for subsequent years. Is this a good idea? In theory, it is a good idea as it can ‘stop the bleeding’ on the ever increasing effective tax rate applied to your foreign mutual funds, but as I mentioned earlier, unless these investments are performing extremely well or unless you are unable to liquidate your investments, you should consider selling your PFICs and investing in less tax disadvantaged investments.

Foreign Life Insurance: Prepare to be Outraged - 7702(g) Income and 720 Excise Taxes

What is Signatory Authority and How Do I Disclose It?