How gain on disposition of a PFIC is taxed
Let’s say you own PFIC stock. (Hint: foreign mutual funds almost certainly are PFICs. So even normal people can own PFICs, to their absolute horror.)
You sell your PFIC stock. Better yet, you sell at a profit. ”Buy low, sell high!” How hard can that be? :-) To make this example extremely simple, I am going to assume that you bought and sold the PFIC stock in a single calendar year, and that the PFIC never paid you a dividend (a “distribution” in PFIC jargon).
How will you report your gain on disposition of the PFIC stock on your tax return? Is this capital gain or ordinary income?
Answer: it depends. I’m going to show you the default method here.
There are three ways that PFIC stock sales are taxed. You will be shackled to using the default method unless you made a “mark-to-market” election or a “QEF” election. If you don’t know what those words mean, then you probably didn’t make those elections and you are forced to use the default method described here.
If you use the default method, the Internal Revenue Code uses the phrase “section 1291 fund” to describe your PFIC. So if you see this phrase on Form 8621 or in the Instructions to Form 8621, now you know what that means.
How much gain is taxed?
If you have a PFIC and you have a disposition, you first have to figure out “Do I have a gain or loss?” according to the normal rules of the Internal Revenue Code. The normal “sales price minus basis” stuff applies. So let’s assume you have gain. (Tax buffs call this “realized” gain. You have income that is theoretically subject to tax, unless you can find a way out of being taxed.)
Now that you know you have realized gain, you have to figure out whether the gain is recognized. (This is tax insider jargon for “the income you received is going to go onto your tax return and tax will be imposed.”) The default assumption of the Internal Revenue Code is that all realized gain will be recognized, unless you can find an explicit exception that applies to you.
These explicit exceptions are called “nonrecognition” provisions in the Internal Revenue Code. Let’s just assume (to make my example easy) that all of your profit from “buy low, sell high” will be recognized.
Ordinary income or capital gain?
At this point we know the gain on sale of your PFIC stock will be taxable. We just don’t know whether it will be capital gain (you owned some stock as an investment, and you sold it) or as ordinary income.
The default PFIC taxation rule is in Section 1291. It is called the “excess distribution” rule. It flatly states that gain from disposition of PFIC stock will be taxed as if it is an “excess distribution.” See Section 1291(a)(2). So now we have to know how an “excess distribution” is taxed.
Again, Section 1291 helpfully (!) hardwired the answer to that question for us. An “excess distribution” is taxed as ordinary income. See Section 1291(a)(1)(B).
Put it on Form 8621
Dispositions of PFIC stock are reported on Form 8621. You will be filing Form 8621 along with your tax return. Here is how you do it:
- First, fill in the top part of Form 8621, page 1. This is where you put your name and address and all that fun stuff.
- Second, in Part I, don’t do anything. You are doing a simple sale of the PFIC stock using the default rules. You didn’t make any elections.
- Part II does not apply to you. It would only apply if you had made a Qualified Electing Fund election. We assume you did not.
- Part III does not apply to you. You did not make a Mark-to-Market election.
- Part IV is where all the guts and glory reside. For you, at least. Lines 10a through 10e will not apply. Our example deals with gain on a disposition only.
- At Line 10f, enter the gain you recognized on the sale of your PFIC stock.
- At Line 11a, prepare the statement that is requested and staple it to the back of your tax return.
- At Line 11b, take the amount of gain that is allocable to the current year (the year you’re doing your tax return for) from the statement you just made, and write in the number. In our example, you bought and sold the PFIC stock in the current year, so all of the gain is reported here on Line 11b. (Pro tip: in my example, the amount on Line 10f is the same as the amount on Line 11b).
- Line 11b tells you to report the number shown on Line 11b as “other income” on your Form 1040. For the 2010 version of Form 1040, this is line 21.
- Lines 11c, 11d, and 11e are all blank.
- Part V doesn’t apply to you, because you never made any elections as to this PFIC.
Ta-DAH! You’re done.
PFIC distributions by nonqualifying funds mean ordinary income
In blog posts here and here I discussed the treatment of disposition gain by a taxpayer who sells a PFIC. In those two blog posts I assumed that a taxpayer bought a PFIC and sold it in the same calendar year, and I further assumed there were no distributions by the PFIC. (I am trying to define as clean and simple a fact pattern as possible so it is easy to identify the moving parts in the taxation of PFIC gain).
Disposition gain is ordinary income
My position was that the disposition gain is ordinary income. One of my readers had a comment and question about how this worked, and whether in fact the disposition gain should be short term capital gain. That would be logical. :-)
The final answer is: ordinary income. You can see the reasoning in the other two blog posts, but my correspondent emailed me with his further research on the point and the way in which he came to the same conclusion.
§1.1291-3(a) says when you have a gain on sale of a PFIC look to §1.1291-2(e)(2), which talks about how the tax is figured, which is our case is ordinary income. It bypasses the calculation of the excess distribution, and that first year exception entirely. So, you are indeed correct.
Tracking the logic through the Proposed Regulations
Here’s what my correspondent is saying. He points to Proposed Regulations Section 1.1291-3(a), which says:
Any direct or indirect disposition of stock of a section 1291 fund within the meaning of paragraphs (b), (c), (d), and (e) of this section is taxable to the extent provided in section 1291, this section, and section 1.1291-6. For dispositions of stock of a section 1291 fund that qualify for nonrecognition treatment, see section 1.1291-6. Gain is determined on a share-by- share basis and is taxed as an excess distribution as provided in section 1.1291-2(e)(2). Unless otherwise provided under another provision of the Code, a loss realized on a disposition of stock of a section 1291 fund is not recognized.
Emphasis added by yours truly.
Proposed Regulations Section 1.1291-2(e)(2) in turn says:
(2) EXCESS DISTRIBUTION –
(i) IN GENERAL. To determine the taxation of an excess distribution, the excess distribution is first allocated pro rata to each day in the shareholder’s holding period (as determined under section 1.1291-1(h)) of the share of stock with respect to which the distribution was made. The holding period of a share of stock of a section 1291 fund is treated as ending on (and including) the date of each excess distribution solely for purposes of allocating the excess distribution.
(ii) ALLOCATIONS INCLUDED IN INCOME. The portions of an excess distribution allocated to pre-PFIC years and the current shareholder year are included in the shareholder’s gross income for the current shareholder year as ordinary income.
(iii) ALLOCATIONS NOT INCLUDED IN INCOME. The portions of an excess distribution allocated to prior PFIC years are not included in the shareholder’s gross income for purposes of this title. These amounts are subject to the deferred tax amount. The deferred tax amount is an additional liability of the shareholder for tax and interest for the current shareholder year. For the calculation of the deferred tax amount and the foreign tax credit that may be taken to reduce the deferred tax amount, see sections 1.1291-4 and 1.1291-5.
Here is how to understand that passage:
- First, you allocate the excess distribution pro rata across the holding period. Prop. Regs. Sec. 1.1291-2(e)(2)(i).
- Then, take the amount that you have allocated to years before the PFIC was a PFIC, and include it in income as ordinary income. The income is reported on the current year income tax return. Prop. Reg. Sec. 1.1291-2(e)(2)(ii).
- Additionally, take the amount of gain you have allocated to the current year, and include it in income as ordinary income on your tax return. Prop. Reg. Sec. 1.1291-2(e)(2)(ii).
- Finally, any excess distribution that is not allocated to the years in which the PFIC was not, uhhh, a PFIC, and any gain that is not allocated to the current year gets treated in a special way. Don’t include it in the shareholder’s income for the current year. Instead, you are going to do a special calculation which will result in a thing called the “deferred tax amount.” Prop. Reg. Sec. 1.1291-2(e)(2)(iii).
As my correspondent points out, this logic tree completely bypasses the calculation of excess distribution–as well as the rules for the first year which define “total excess distribution” (not “excess distribution”) as zero in the first year of the holding period. We are starting with the assumption that the disposition gain is excess distribution, because the
Bible Internal Revenue Code told us so. [Did that cue up a little song in your head from your childhood? It did for me. ].
Internal Revenue Code Section 1291(a)(1)(B)(i) says:
(1) Distributions. If a United States person receives an excess distribution in respect of stock in a passive foreign investment company, then–
(A) the amount of the excess distribution shall be allocated ratably to each day in the taxpayer’s holding period for the stock,
(B) with respect to such excess distribution, the taxpayer’s gross income for the current year shall include (as ordinary income) only the amounts allocated under subparagraph (A) to–
(i) the current year, or
* * * *.
Thanks to reader CP for this. It forced me to go back and read the Code and Proposed Regs and think things through. It is one of the reasons why releasing is so important. For those of you outside the priesthood of tax arcana, it gives you a glimpse into why tax law is so damned hard to do.
In conclusion, a simple declarative statement (because Don Schaut told me when I was a young pup lawyer that clients are grownups and deserve straight answers):
If you buy PFIC stock and sell it in the same year at a gain, the gain is treated as ordinary income, not short-term capital gain.
Why the steady stream of PFIC posts?
We do a lot (and I do mean a LOT) of work with PFICs — Passive Foreign Investment Companies. As a result we have a lot of stuff on this topic stored in our collective brains at the firm. We also have fiercesomely complex spreadsheets designed by David, and tweaked by David, Elena, and Debra.
I’m writing these blog posts in an effort to remove some of the witchcraft and tom-foolery out of PFICs and the preparation of Form 8621. Expect a metric ton of posts on the topic. I have not yet begun to tax-nerd out on you.
Feel free to ping me questions about PFIC issues. I have a steady accumulation of topics sitting in Evernote waiting for action. I’ll get to it eventually.
Also, please drop a comment or ping me an email if you think I’m dreadfully off the rails on my interpretation of All Things PFIC. It helps me get smarter, and it helps the other readers when bad information gets corrected.
Time required to prepare Form 8621
Our consistent advice to U.S. taxpayers is “Sell all of your foreign mutual funds.” Foreign mutual funds are almost always Passive Foreign Investment Companies — PFICs. We tell people to get rid of foreign mutual funds and buy individual stocks and bonds.
The advice has nothing to do with investment strategy. It has everything to do with preventing brain damage and huge tax return preparation bills. Form 8621 is a bear to prepare.
For kicks, download the Instructions to Form 8621. (PDF). Flip to the bottom of the last page of the Instructions. There the IRS gives you the estimated amount of time required for you to prepare Form 8621:
The time needed to complete and file this form will vary depending on individual circumstances. The estimated burden for individual taxpayers filing this form is approved under OMB control number 1545-0074 and is included in the estimates shown in the instructions for their individual income tax return. The estimated burden for all other taxpayers who file this form is shown below.
Here are the time estimates by the IRS:
- Recordkeeping: 13 hrs., 37 min.
- Learning about the law or the form: 8 hrs., 38 min.
- Preparing and sending the form to the IRS: 9 hrs., 14 min
Grand total? 31 hours, 29 minutes. YMMV. I personally have spent more than 8 hours learning about the law this week. And I live on Planet Tax and frolic in the PFIC playground, so I am somewhat acclimatized. For those of you without a lot of background in PFICs and Form 8621, the damage is probably worse.
PFIC disposition and the excess distribution rule
Correspondent C (thanks!) read my prior blog post about how the excess distribution rule would treat recognized gain on a purchase and sale in the same year, and pointed me to Section 1291(b)(2)(B). Wouldn’t that seem to indicate that we should treat the gain as capital gain rather than ordinary income?
Remember we’re talking about the simplest of investments: buy PFIC stock and sell it in the same year, at a profit. We are assuming that there are no distributions–dividends, etc. For the example, let’s assume you bought the PFIC stock at $1,000 and sold at $1,500.
Is there gain recognized?
In order to determine the tax imposed on disposition of PFIC stock, you must first figure out the amount of gain recognized. In order to do that you figure out the amount of gain realized (according to the Internal Revenue Code, do you have something that is theoretically taxable?), then you figure out whether in fact that gain will be taxed–is the gain recognized?
Example: think of interest income. You buy a bond and you earn interest. You have realized interest income. But is it recognized (i.e., something on which you pay tax)? If it is a regular corporate bond, yes. The interest income is taxable. But if you bought a municipal bond, the answer is no–your income is not recognized because there is an exception that says interest on muni bonds is tax-free.
The same thing happens here. You bought PFIC stock at $1,000 and sold at $1,500. You have realized a $500 gain. The default assumption in the Internal Revenue Code is that this gain is taxable (i.e., recognized) unless you find a “nonrecognition” provision that make that gain not be recognized–i.e., not be taxable. You can see the nonrecognition provisions for PFICs in Proposed Regulations Section 1.1291-6.
Since we have an extremely simple fact pattern (by assumption), let’s assume that the entire $500 gain on disposition of the PFIC stock is recognized.
We now know how much is going to be taxed–$500. The big question is HOW is it going to be taxed?
PFIC gain on disposition is taxed as excess distribution
At first glance, logic would tell you that you have a capital asset (the PFIC stock) that you sold, so the gain should be capital gain. It should be short term capital gain because you didn’t hold the PFIC stock for a year. Logic would lead you astray.
The PFIC rules alter the character of the $500 gain. The gain is characterized as being an “excess distribution.” [Section 1291(a)(2); Proposed Regulations Section 1.1291-3(a)]. We are not dealing with a capital gain now. We are dealing with an “excess distribution.” Whatever THAT is.
Excess distributions are taxed as ordinary income
If you have an “excess distribution,” it is taxed as ordinary income. [Section 1291(a)(1)(B).
What is an excess distribution?
The idea of an excess distribution is meant to capture and tax distributions by a PFIC. Think dividends paid to shareholders. Think distributions to you because you own some shares of a foreign mutual funds. You receive distributions every year. Are they ordinary income or capital gain? The excess distribution calculation helps you figure that out.
The definition of an excess distribution is found at Section 1291(b)(1). I will deal with this in excruciating detail some other time. The idea is that you do some advanced math, subtracting the distributions you receive in a current year from a thing called the "total excess distributions" which is a term defined at Section 1291(b)(2).
And in the definition of "total excess distribution" there is a special rule that applies to the first year that you own a PFIC. It says that for that first year, the "total excess distribution" is defined as equal to zero. [Section 1291(b)(2)(B)].
At first you would think this applies to our little fact pattern and our quest to determine how the $500 gain on disposition of PFIC shares should be taxed. But in fact it doesn’t.
Section 1291(b)(1) is just the mechanism for looking at a particular dividend or distribution received, and determining whether it is an “excess” distribution or a “nonexcess” distribution. If you do the math and calculate that you have an excess distribution, then you hike off to Section 1291(a)(1)(B) and are told to tax that excess distribution as ordinary income. If you do the math and calculate that you have something that isn’t an excess distribution, then you are left to the general rules of the Internal Revenue Code to figure out how it’s taxed.
Disposition gain is defined as 100% excess distribution
But here we don’t care about calculating the excess distribution under Section 1291(b)(1). That’s because we are told–forced–to treat the whole gain on disposition as if it is an excess distribution. [Section 1291(a)(2)]. So the fact that Section 1291(b)(2)(B) says something about “total excess distribution” in year one as being zero will not matter.
Disposition gain always excess distribution; distributions not always
This conclusion is echoed in the Blue Book for the 1986 Tax Act, at page 1027:
This rule provides that all gain recognized on the disposition of PFIC stock must be treated as ordinary income. The portions of distributions that are not characterized as “excess” distributions are, of course, subject to tax in the current year under the general Code rules. [Emphasis added.]
(The Blue Book [warning! gigantic PDF!] is a God-awful thousand-plus page document written by the staffers of the Joint Committee of Taxation summarizing the changes of the 1986 Tax Act. The phrase “Blue Book” means the legislative summary of the tax laws passed in a particular Congress. There are a bunch of Blue Books. As long as we continue to elect people to Congress, we will continue to get more Blue Books.)
Disposition gain for PFICs is always going to be taxed as an excess distribution, therefore always ordinary income. Distributions from PFICs are subjected to the mathematics of Section 1291(b) to determine how much of the distribution will be deemed to be “excess” therefore ordinary income, and how much will not be characterized as “excess,” therefore taxed under one of the myriad of other rules in the Internal Revenue Code.