PFIC 101: How to Avoid PFIC Excess Distribution Interest Penalties
Once U.S. taxpayers identify passive foreign investment company assets in their portfolio, the next logical step is to minimize the tax consequences connected to those assets. At the top of the list is finding a way to avoid PFIC excess distribution interest penalties.
This is the fourth post in a blog series helping U.S. taxpayers who own stock interest in foreign companies understand their reporting and tax obligations. Previous posts covered the definitions of Passive Foreign Investment Companies (PFIC) their reporting and PFIC tax obligations and how to tell if you have PFIC stock interests. This final post will describe what you can do to avoid PFIC excess distribution interest penalties.
Purging the PFIC Taint
PFICs come with substantial taxes and penalty interest, not to mention and ongoing accounting obligations. That is especially true when PFIC excessive distributions come into play. But the IRS's "once a PFIC, always a PFIC" rule can make it hard to proactively avoid investments with high tax consequences. To avoid interest penalties, U.S. taxpayers will need to look for ways to "purge" the PFIC taint.
Remember that Qualified Electing Funds (QEFs) don't suffer the same tax consequences as unqualified PFICs. Instead, income, losses, and capital gains of a pedigreed QEF are treated as ordinary income on a pro rata basis for each shareholder's taxes. This avoids ongoing PFIC excess distribution interest penalties and the costs associated with accounting for those assets. So how does a PFIC become a QEF?
QEF Elections Put PFIC Tax Penalties on Hold
A PFIC's shareholders may make a QEF election at any time - even before the company qualifies as a PFIC. Who makes the election depends on the type of entity involved:
- Shareholders can make the election, even if they were not a shareholder at the time, as long as it was within the same year
- Domestic partnerships make the election themselves, but for foreign partnerships, the US shareholder makes the election
- Grantor trust owners can make the election.
- Foreign nongrantor trust beneficiaries make the election
- Parent companies of affiliated groups can make the election in a consolidated return
The QEF election is made along with the tax return for the same year. It is made by filing Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or a Qualified Electing Fund, and renewed each year.
The election itself doesn't have any tax consequences. But it also doesn't purge any PFIC taint from before the election. Instead, it puts the tax penalties on hold. If the QEF is unpedigreed, the "once a PFIC, always a PFIC" rule still applies. When a shareholder disposes of unpedigreed QEF stock, the gain of that transaction is treated as a PFIC excess distribution.
Shareholder Purging Elections Remove PFIC Excess Distribution Interest Penalties
To go the next step and eliminate PFIC excess distribution interest penalties, shareholders must make a purging election on their shares. Like the QEF election, this purging election must be made on Form 8621 along with the tax return for that year. Unlike the QEF election, this does have immediate shareholder tax consequences.
Taxpayers making a purging election are treated as if they sold their PFIC shares for a fair market value at the time the company became a QEF. They must recognize gain from deemed sales of the PFIC stock, together with a dividend for their share of any post-1986 earnings. The shareholders will have to pay taxes on those dividends and gains at the time of the election, but then the PFIC taint will be purged and there will be no future PFIC excess distribution interest penalties.
Making a Late Election
The owners of PFIC stocks often don't realize their reporting requirements or tax obligations in time to make timely purging and qualifying elections. The IRS does allow some taxpayers to make retroactive QEF and purging elections, but in most cases it requires an explanation of why the election wasn't made on time. Sometimes it is enough to prove the taxpayer reasonably did not know the PFIC's status. In other cases the taxpayer will also have to show he or she knew the laws and attempted to comply with them.
Making the case for a late election, and determining whether a purging election is worth the cost, require a full understanding of the PFIC laws and their effects. Taxpayers are well-advised to get professional assistance from tax preparers and attorneys familiar with the code. They can help shareholders consider their options and make the necessary elections to purge the PFIC taint and avoid PFIC excess distribution interest penalties.
Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions about avoiding PFIC excess distribution interest penalties, contact Joe Viola to schedule a consultation.