Back to basics: How to report gain on the sale of a PFIC
Hello from Debra Rudd.
Back to basics: How to report gain on the sale of a PFIC
This question came from an anonymous reader:How does one report a gain on the sale of a PFIC? What if such PFIC was not eligible for Qualified election?Now this I can answer. And I love questions like this, because it reminds me that at the beginning, just understanding how to report a gain from a sale of a PFIC (nevermind performing the calculations and filling out the forms correctly) can be a daunting task. I’m going to assume that not only is the PFIC ineligible for the QEF treatment, but also that it was ineligible for Mark to Market treatment, as well (or that no Mark to Market election was made). When neither the QEF nor Mark to Market election is made, the PFIC is taxed according to the rules of Internal Revenue Code § 1291. In this email I will explain how a gain from a sale of a PFIC is taxed under that section.
The scenario
Let’s assume you, a US citizen, purchased 100 shares of a foreign mutual fund on January 1, 2012 for $10,000. The fund never paid any dividends to you. You never made any subsequent purchases. You sold your 100 shares on December 31, 2014 for $16,000. You have a gain of $6,000. How is that gain taxed?Gains are taxed as excess distributions
IRC § 1291(a)(2) says that you treat the gain from a disposition as if it is an “excess distribution”:If the taxpayer disposes of stock in a passive foreign investment company, then the rules of paragraph (1) shall apply to any gain recognized on such disposition in the same manner as if such gain were an excess distribution.To understand how the gain on sale of your mutual fund is taxed, you need to understand how an excess distribution is taxed. That means we will be looking at the rules for what you do with an excess distribution. The taxation of an excess distribution or a gain from the disposition of a PFIC can be broken down into a step-by-step process.
Step 1: Figure out the total gain
This part is simple. We’ve already done it. You have a gain of $6,000. The gain of $6,000 is reported on Form 8621, Part V, Line 15f. You are also supposed to attach a statement to the form, according to Line 16a, which I won’t talk about in this newsletter. But you should be aware the statement requirement exists.Step 2: Allocate the excess distribution over the holding period
The first thing you do is allocate the gain “ratably to each day in the taxpayer’s holding period for the stock”. IRC § 1291(a)(1)(A). (The term “ratably” means “proportionally”.) To do this, you determine the total number of days in the holding period. In our example, ignoring leap years, you have held the mutual fund stock for 3 years, or 365 days x 3 = 1,095 days. Now you determine your gain per day. Your total gain is $6,000, so you divide that by the number of days in the holding period. Your gain per day is $6,000 / 1,095 days = $5.48 per day. In real life, you do not purchase securities on January 1 and sell them on December 31, so you will need to use Excel to do this calculation.Some background before Step 3
Here’s where it starts to get a little weird. Conceptually, the way this works is that you separate your gain into three distinct time periods, once you have determined the gain allocable to each day of your holding period. Each of those time periods is subject to a different method of taxation.- The first is the “pre-PFIC period”. This is “any period in the taxpayer’s holding period before the 1st day of the 1st taxable year of the company which beings after December 31, 1986, and for which it was a passive foreign investment company”. IRC § 1291(a)(1)(B)(ii). In other words, the pre-PFIC period is the period during which you held the fund but it was not yet a PFIC (in any year after 1986). It could also be the time that you owned the PFIC before you were a US person. Prop. Reg. §1.1291-1(b)(1)(i), (3); 57 FR 11024.
- The second is the time period after the pre-PFIC period and before the current year. I often refer to this as the “prior years PFIC period”.
- The third is the “current year”, which in our example would be calendar year 2014.
Step 3: Figure out gain allocable to current year and prior years PFIC period
You have 2 years (2012 and 2013) in the prior years PFIC period. 2014 is the current year. Your gain per day is $5.48. The prior years PFIC period has 730 days (365 * 2). Therefore your gain allocable to that period is $5.48 * 730 = $4,000 (or $2,000 per year). The current year period has 365 days. Your gain allocable to the current year is $5.48 * 365 = $2,000.Step 4: Current year gets ordinary income treatment
According to IRC § 1291(a)(1)(B), “the taxpayer’s gross income for the current year shall include (as ordinary income)…the amounts allocated…to the current year”. If you look at Form 8621, you will see that it gets reported not only in Part V of that form (on Line 16b) but also on Line 21 of Form 1040 as other income. The $2,000 allocated to the current year will be ordinary income.Step 5: Prior years PFIC period tax computation: the tax component
The gain allocated to the prior years PFIC period is not included in ordinary income like the current year portion of the gain. Instead, the tax and interest you calculate on this portion of the gain are added directly to your tax on page 2 of Form 1040. To calculate out the tax and interest on the prior years PFIC period, you start with the tax. IRC § 1291(c)(2) explains how this works, and calls the tax you calculate the “aggregate increases in taxes”:For purposes of paragraph (1)(A), the aggregate increases in taxes shall be determined by multiplying each amount allocated under subsection (a)(1)(A) to any taxable year (other than any taxable year referred to in subsection (a)(1)(B)) by the highest rate of tax in effect for such taxable year under section 1 or 11, whichever applies.You apply the highest tax rate for each year to the gain allocated to that year. The gain allocated to 2012 is $2,000. The highest tax rate for 2012 was 35%. The tax for 2012 is $2,000 * .35 = $700. The gain allocated to 2013 is $2,000. The highest tax rate for 2013 was 39.6%. The tax for 2013 is $2,000 * .396 = $792. Recall that the gain allocated to 2012 and 2013 will not be reported in income. Instead, you report the total of the tax you just calculated ($1,492) on Form 8621, Part V, Line 16c and then carry it to Form 1040, Line 44.
@Frank if you have made a MTM election, that’s correct, you increase your basis each time you include a MTM gain in income. Then when you sell, your taxable gain is the difference between the proceeds of the sale and your adjusted basis (which would have been increased over the year for all the MTM gains previously recognized, and decreased over the years for all the MTM losses previously recognized). But if you don’t have the MTM election in place, and you are operating under the rules of Section 1291, then you are not recognizing mark to market gains each year, not increasing your basis for those gains each year, and you are subject to the excess distribution rules I describe above on the full gain.
@DS, all of these are good points. Thank you for adding these to the topic. It is tough to be comprehensive on such a complex topic!
Thanks for the detailed explanation. One other question that wasn’t clear. Let’s say in the example that a fund was purchased in 2012 and sold in 2014. I get the “prior years PFIC period” but what isn’t clear is how you account for tax paid if you filed 8621 in (e.g., 2013). I’m assuming that the fact I filed a 2013 form and (e.g.) mark-to-market election for this fund would increase my basis. That is, on selling the share the “gain” I must account for is only the increase in capital gain from 2013-2014, not the entire period.
Otherwise we would be taxed twice on the gain? The thing that is still unclear is that the prior years are taxed at marginal tax level (say 30%) while the sale is supposed to allocate things according the maximum bracket (39.5%).
Good explanation. In reality (as you’ve acknowledged) it’s more complicated in that it would be rare to buy on Jan. 1 and sell on Dec. 31, so (as you’ve pointed out) the gain each year is allocated as the number of days the fund was held during that year, divided by the total number of days it was held.
Also, the tax must be calculated for each lot with a different hholding period (if you buy shares and sell some on one date and the rest on another date, you have two lots.)
Should you have a loss on one of the lots, it does NOT offset gains on other lots as far as PFIC tax is concerned; PFIC losses are treated the same way as any other capital losses.
Finally, all these calculations require you to create a spreadsheet (for each lot) and you must attach a copy showing the calculations to your return. To put it another way, there does not exist an IRS form for calculationg PFIC gains.