Hello from Haoshen Zhong.
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This is an inquiry we get from time to time:
I have a foreign fund that I think is a PFIC. I can’t believe the taxes that I have to pay on this. Can I get rid of the tax problem by giving the PFIC shares away?
Why do people ask this? PFICs carry a heavy U.S. income tax burden. If a U.S. person can give PFIC shares to a non-U.S. relative – without any tax complications – then the non-U.S. relative can sell the PFIC shares without worrying about U.S. income tax.
The answer, at least according to the IRS in Proposed Regulations, is no. If you give away PFIC shares, you have to pay income tax on the gain.
There are three ways that dispositions of PFIC shares can be taxed.
Two methods (mark-to-market and the qualified electing fund) require you to make an election with the IRS. We find that people who ask the “Can I give away my PFIC shares?” question are people who have not made those elections, because they were not aware of the special rules that apply to PFICs, and are contemplating massive and unexpected tax bills.
So, for this discussion, I will assume that the PFIC shares will be taxed under the excess distribution rules. (You will find these rules in IRC §1291).
If you held the PFIC shares for a long time, this can create a very large tax bill.
The normal situation, when you make a gift, is that you do not have taxable capital gain. Instead, you hand the tax problem onward to the recipient of the gift. The recipient owns the asset with your tax basis as his or her acquisition cost. As a result, the gift recipient pays the capital gain tax when selling the asset.
For PFICs, gifts might be treated differently. The override (see IRC §1291(f)) occurs when two criteria are met:
Specifically, this is what the Internal Revenue Code says:
To the extent provided in regulations, in the case of any transfer of stock in a passive foreign investment company where (but for this subsection) there is not full recognition of gain, the excess (if any) of–
(1) the fair market value of such stock, over
(2) its adjusted basis,
shall be treated as gain from the sale or exchange of such stock and shall be recognized notwithstanding any provision of law.
Giving away your PFIC shares is a transfer. The shares move from your control and possession to your family member. The first criterion is satisfied.
This leaves us with the second criterion: Is this a transfer where there is not full recognition of gain under normal rules?
In the Proposed Regulations, the position taken by the IRS is clear: a gift of PFIC shares triggers recognition of gain.
A nonrecognition transfer includes, but is not limited to, a gift . . . .
Prop. Reg. §1.1291-6(a)(2).
Proposed Regulations section 1.1291-6(b) tells us that section 1291(f) recognition applies:
Unless otherwise provided in paragraph (c) of this section, a shareholder recognizes gain on any direct or indirect disposition of stock of a section 1291 fund in accordance with the rules of 1 1.1291-3, without regard to whether the disposition is a result of a nonrecognition transfer as defined in paragraph (a)(2) of this section.
Prop. Reg. §1.1291-6(b).
There are some exceptions, but in general, if you give away a PFIC, the IRS says you have to recognize gain. Giving away the PFIC to a nonresident alien family member is not one of the exceptions.
Answer: not very.
Proposed Regulations are not necessarily the law. Proposed Regulation section 1.1291-6 was originally published on April 1, 1992. 57 FR 11024. We might wonder whether the IRS position (“a gift of PFIC stock will trigger a tax liability for the donor”) is correct or not.
You may have read Phil’s post “The Stealth Exit Tax, PFIC-Style” back in May. In that post, Phil explained why Proposed Treasury Regulations are not binding law. A few court case citations to illustrate:
The IRS also recognizes that Proposed Regulations are not binding law:
Proposed regulations provide guidance concerning Treasury’s interpretation of a Code section. The public is given an opportunity to comment on a proposed regulation and a public hearing may be held if a sufficient number of requests to speak at a hearing are received. Taxpayers may rely on a proposed regulation, though they are not required to do so. IRM 18.104.22.168.3.3.1.A (2006-01-01).
Although the Internal Revenue Manual itself is not law (it is just the procedure manual for IRS employees), it at least tells us that the IRS is aware that Proposed Regulations are not binding law.
Even if you think that the Proposed Regulations are not binding law, you cannot simply ignore them and make up your own rules. You need a reasonable legal basis for concluding that IRC §1291(f) does not apply to gifts of PFIC stock.
Here is an idea for you to think about. I am not saying it is a good idea, and I am not saying that you will succeed in persuading a Tax Court judge. This idea is presented for you to think about and find fault with.
The premise is that the Proposed Regulations do not properly apply the ideas of “realization” and “recognition” of gain.
Here is a quick walk through the Code to explain the logic.
The amount of gain you have when you dispose of an asset – and how much is taxable – is determined by IRC §1001, in a methodical, step-by-step way:
This means, in calculating your taxable gain (and therefore your tax liability), you take your “realized” gain, and do the following:
Let us look at a gift and see how this method applies.
For gifts, you do not need to find a nonrecognition rule, because you realized no gain to begin with. The reason you have no taxable gain is because you have no recognized gain. The reason you have no recognized gain is because you have no realized gain. The reason you have no realized gain is because you made a gift, not a sale, and by definition got nothing in return when you gave the thing away.
It is possible to concede the truth of Section 1291(f) and still claim that a gift of PFIC shares does not trigger an income tax liability.
Section 1291(f) imposes tax:
“in the case of any transfer of stock in a passive foreign investment company where (but for this subsection) there is not full recognition of gain. . . .”
A gift has no gain recognition for the simple reason that there is no gain realized, not because there is no gain recognized.
On the theory that Congress knows what it means when it writes laws, it would be reasonable to say that if Congress meant for gifts of PFIC shares to be taxable under the income tax rules, it would have written Section 1291(f) so that it triggered realization of gain under IRC §1001(b), so that, for instance, IRC §1291(f) would say:
. . . in the case of any transfer of stock in a passive foreign investment company where (but for this subsection) there is not full realization of gain. . . .
If Congress had done that – forced realization of gain in the event of a gift of PFIC shares – then the normal gain recognition rules would apply, and the normal rules of PFIC taxation would be invoked to cause the donor to pay tax.
And that, in a nutshell, is the theory that you would pursue. “Realization” vs. “recognition”.
My thanks goes to Virginia Jeker for pointing this out.
When the courts see a controversy about statutory interpretation, it usually turns to legislative history to help interpret that statute. The Joint Committee on Taxation issued an explanation of section 1291(f) in its Description of the Technical Corrections Act of 1988 (H.R. 4333 and S. 2238):
“The bill clarifies that the regulatory authority provided under the Act to deny the benefits of any nonrecognition treatment extends to any transfers of PFIC stock, including transfers at death or by gift.” JCS-10-88, 296.
Congress’ intention for enacting section 1291(f) is clear: Congress does not want a taxpayer to avoid tax on PFICs by giving them away. This is another unfortunate case of Congress using words in an inconsistent manner in the Code.
An IRS examiner must follow the Proposed Regulations when conducting an audit. IRM 22.214.171.124.3.3 (2006-01-01). If you give away your PFIC shares, an IRS examiner will assess tax using IRC §1291, based on fair market value minus adjusted basis. If you are examined, expect to get this resolved in Tax Court.
This post is not tax advice to you, and in fact you should not rely on my alternate theory at all when taking a tax position on gifts of PFIC stock. Get advice from a tax adviser before you try this.