July 2, 2015 - Debra Rudd

Back to basics: How to report gain on the sale of a PFIC

Hello from Debra Rudd.

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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.

The taxation for the pre-PFIC period and current year is relatively simple. The gain allocated to those periods is reported on Line 21 of Form 1040 as ordinary income.

The taxation for the prior years PFIC period is complicated. For the amount allocated to each calendar year in this period, you apply the maximum tax rate for each year to that year’s portion of the gain, and then you calculate a daily compounded interest charge.

Our example does not have the first time period on the list, the pre-PFIC period. You were a US citizen when you purchased the mutual fund and it was a PFIC at the time you purchased it. Therefore, we will only be looking at the second and third time periods.

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.

Step 6: Prior years PFIC period tax computation: the interest component

The interest charge is explained under IRC § 1291(c)(3). You treat each year’s aggregate increase in tax, as just calculated, as an underpayment of tax due on the due date of individual tax returns for that tax year and calculate interest through the due date of the return you are reporting the sale on.

For the 2012 tax amount of $700, you treat it as an underpayment which was due April 15, 2013, and calculate the interest through April 15, 2015. (There was not actually any tax due on April 15, 2013. It is just treated that way for the purpose of calculating the interest portion of the PFIC tax.)

For the 2013 tax amount of $792, you treat it as an underpayment which was due April 15, 2014, and calculate the interest through April 15, 2015. (Again, there was not actually any tax due on April 15, 2014. It is just treated that way for the purpose of calculating the interest portion of the PFIC tax.)

I am not going to go through detailed interest calculations here. I use a computer program for that. It told me the interest charge is about $67. That $67 gets reported on Form 8621, Part V, Line 16f, and is carried to Form 1040, Line 62.

You’ve reported the gain from sale of a PFIC

That’s it. Apart from filling out the required Page 1 information on Form 8621, you are done.

For the sake of simplicity, I left out the foreign tax credit on Line 16d of Form 8621, Part V. You may be able to use that credit. For today, I wanted to focus on the basics of doing the calculations and reporting the gain from a PFIC under the IRC § 1291 rules.

I also didn’t talk about excess distributions except in the context of gains from dispositions. If you have to calculate your excess distributions from distributions you receive, that is another world entirely.

Thank you

Thanks for reading, and a quick obligatory disclaimer: this is not advice to you. I vastly oversimplified these calculations to show conceptually how reporting a gain from the sale of a PFIC works. In the real world, this is not so neat and clean.

See you next week.