PFIC Rules Demystified: 3 Steps To Clarity On IRS Form 8621

Note: This blog post was adapted from a recent newsletter article on PFIC rules. We like to demystify international tax matrers, and we get a bit chatty sometimes. If that suits you, get our newsletter here.

Distributions, excess distributions, and total excess distributions

This topic occurred to me while preparing the slides for an upcoming Webinar. I am talking about taxation of distributions under the default PFIC rules: Section 1291.

In order to know how distributions are taxed, you need to know about the concept of "excess distributions". PFIC rules say: distributions are taxed, and excess distributions are taxed heavily.

This email explains the first part of the job. What is an excess distribution, and when, exactly, did you receive it? The second part of the job (calculating the tax and interest) is something to cover another time.

The critical number you need is the "excess distribution" amount. Therefore, it only makes sense that we figure this out by starting somewhere else. Why on earth would you start with the definition of the thing you want to know about? :)

“Total excess distribution” defined

We start with the definition of “total excess distribution,” defined in IRC § 1291(b)(2)(A) as follows:

The term “total excess distribution” means the excess (if any) of—

(i) the amount of the distributions in respect of the stock received by the taxpayer during the taxable year, over

(ii) 125 percent of the average amount received in respect of such stock by the taxpayer during the 3 preceding taxable years (or, if shorter, the portion of the taxpayer’s holding period before the taxable year).’

Ah yes. The familiar old “125% of the average of the prior three years’ distributions”. PFC Rules have a truly Kafaesque logic.

(For those of you who looked up Section 1291(b)(2)(A) and are wondering where the rest of it is, I’m ignoring the flush language because there’s enough to talk about today. The flush language is a standalone topic entirely.)

The math

To do the math and compute total excess distributions, here's what the PFIC Rules say:

1. Figure out the total distributions received from the PFIC during the current year.
2. Add up the total distributions received from the PFIC during the three prior years, divide by three, then multiply that by 1.25.
3. Line 1 minus Line 2 = the total excess distribution for this year (from PFIC distributions, not PFIC dispositions).

Example

You received $540 of distributions from a PFIC in the three prior years, so the average for these three years is $180. Multiply $180 by 125%, and the result is $225.

If you receive more than $225 of PFIC distributions in the current year, the amount above $225 will be your total excess distribution.

Form 8621

You can find these steps on Form 8621, Lines 15a through 15e.

(And yes, there is Line 15f, which says that whenever you dispose of a PFIC the entire amount is an excess distribution, but that is a topic for another edition of PFICs Only. This week’s episode is just about distributions, not dispositions.) The

“Excess distribution”

Now that we have "total excess distributions" for the current year, we calculate the number we really want.

The Code

The definition of “excess distribution” is found in IRC § 1291(b)(1), and it is ever-so-slightly confusing, like the rest of the PFIC rules:

For purposes of this section, the term “excess distribution” means any distribution in respect of stock received during any taxable year to the extent such distribution does not exceed its ratable portion of the total excess distribution (if any) for such taxable year.

Forty-three words, and the word "distribution" is used four times. Almost 10% "distribution" by weight, this definition is.

What on earth, dear Congress, are you trying to say? I confess I have stared at this definition with a perplexed and angry look on my face at least a few times over my career. Some of those happened more recently than I would like to admit.

Now that you have figured out the total excess distribution for the year, you need to calculate the tax and interest for each distribution received.

Why? (PFIC Rules and the Date of Distribution)

Why do you have to split up the total excess distribution among all the distributions? Why is this necessary?

I will come back to that in a minute, but the short answer is that you need to use the date of the distribution in your tax and interest calculations for each excess distribution.

Different distribution dates means different tax and interest calculations, and this in turn means an actual impact on the numbers you report on your tax return.

How it works: PFIC rules and multiple distributions

The idea is simple. Spread out your total excess distribution “ratably” to each distribution you received during the year.

It works like this:

• You receive multiple distributions from a single PFIC in a year.
• You calculate your total excess distribution from the total of all the distributions you received in the year, using the “125% of the average of the three prior years’ distributions” formula.
• Then you allocate the total excess distribution based on the proportion of each distribution to the total of all distributions for the PFIC. The result is that to each distribution, a portion of the total excess distribution for the year is assigned.

After you have done that, each distribution will consist of a nonexcess distribution portion, an excess portion allocated to the current year, and an excess portion allocated to the prior years of the holding period of the PFIC. These (finally) are the numbers you need to calculate the tax under the PFIC rules.

Form 8621: 3 Steps To Clarity

Form 8621 tells you to do a lot of work on Line 16a. Note that you do not actually write any numbers in on Line 16a. You just generate a massive pile of statements. This is where the computation of the excess portion of each distribution occurs: in your statements.

Example

Let’s do a quick example for when you have multiple distributions in a year (all on different dates) and need to calculate the excess distribution for each of those.

Step 1: Distributions

Pretend you own shares of a foreign mutual fund. The foreign mutual fund pays you a dividend of $100 in April and $150 in October for a total of $250 in distributions for the year.

Let’s assume that the average of the 3 prior years’ distributions for this fund is $180.

Step 2: Total Excess Distribution

First you will figure out what the total excess distribution is, applying the language of IRC § 1291(b)(2)(A).

This is done by finding 125% of $180, which is $225. Any amount received in the current year that is over $225 will be your total excess distribution.

Your total excess distribution is $25 because you received total distributions of $250 in the current year, and $250 minus $225 is $25.

Step 3: Excess portion of each distribution

Now you apply the language of IRC § 1291(b)(1) to calculate the ratable portion of the total excess distribution. How much of each distribution is an excess distribution? Here is how the PFIC Rules Apply in this case:

For the April distribution, divide the distribution ($100) by the total distributions from the fund in the year ($250) to get a percentage: 40%.

Then you multiply that percentage by the total excess distribution ($25). The result is $10.

This means that you will allocate $10 of the total excess distribution to the April PFIC distribution. This is the excess distribution portion of the $100 distribution received in April. The other $90 of the April distribution is . . . well . . . non-excess.

For the October distribution, divide the distribution ($150) by the total distributions from the fund in the year ($250) to get a percentage: 60%. Multiply the total excess distributions ($25) by that percentage. The result is $15. The October distribution of $150 is therefore made up of $15 excess distribution and $135 non-excess distribution.

PFIC Rules And The tax consequences (why we are here)

You may be wondering why you need to go through all the trouble of proportionally allocating your “total excess distribution” to various distributions throughout the year. Isn’t the total the total no matter how you slice it? (I promised I would come back to this.)

In order to calculate the tax and interest charge on an excess distribution, you need to know the holding period. Excess distributions are prorated across the entire holding period by day.

Every time you receive an excess distribution, the holding period starts with the date of acquisition of the PFIC shares and ends with the date you received the distribution. IRC § 1291(a)(3)(A)(i) says to treat the date of the distribution as the end of the holding period for purposes of allocating the excess distribution and calculating tax.

This means that the April distribution and the October distribution, in my example, have two different holding periods, and therefore two different tax computations will be necessary. These two different tax computations will be supported by statements (required by Line 16a of Form 8621).

Some of the excess distribution will be pro-rated by day across the holding period into the current year. This amount goes onto Form 8621, Line 16b, then transports itself to Form 1040, Line 21 as other income. The April distribution will have less here than the October distribution, for obvious reasons.

The rest of the excess distribution amount is allocated to prior years. The tax is calculated on these amounts and written on Form 8621, Line 16c, then (after deducting foreign tax credits) ends up on Line 16e, which then transfers as an additional tax to Form 1040.

Finally, you calculate an interest charge on the Line 16e amount. This, too, is transferred to Form 1040.

And what do you do with the non-excess distribution?

For non-excess distributions, this is relatively easy (Finally! Something easy!). They are taxed according to IRC § 301, which says that distributions are classified as dividends, return of capital, or capital gain.

PFIC Rules Make My Head Hurt

My head hurts. Yours probably does, too. Imagine doing these calculations for 207 mutual funds, all of which are relatively low in value (yes, I did that project). All of which pay out an average of $100 in dividends each year. (Plus there are sales. Many, many sales. I’m not even going to talk about those here.) You end up doing months upon months of work to determine that you owe a total of $11,000 of tax and interest. Surely your time must be worth more than that? Surely there must be some shortcut? Some minimum bogey below which you don’t have to bother with all of this?

Unfortunately, no. These rules were designed to prohibit US persons holding foreign mutual funds and other PFICs. Not just in terms of the tax calculations -- maximum tax rates and daily compounded interest charges -- but in the sheer volume of work required to comply with the US tax law, and the tax preparation fees that go with it.

If you're interested, we did another post on this topic, just covering PFIC Rules on a sale gain.

I love this topic because it is complicated and confusing and I have managed to gain a decent understanding of it over the years. It gives me a sense of accomplishment and, dare I say it, fulfillment. But that’s purely in the abstract. I hate what it does to regular, law-abiding people who want to be fully tax compliant and not spend their nights fretting and waiting for the other shoe to drop. I hope that someday a more sane set of rules will apply. But I don’t expect it to happen.

Until next week

I have uttered the words “distribution,” and “excess distribution,” and “total excess distribution” too many times this week. To allow the semantic satiation to wear off, next week’s newsletter will cover a different PFIC topic, maybe PFICs and Children.

We're looking forward to the next installment of this series—be sure to refer your friends out to our newsletter.

Do you have questions about PFIC Rules?

Feel free to ask here. We can't answer everything, but we will point your research project in the right direction.