October 17, 2017 - Haoshen Zhong

Cash Distribution from a Mark-to-Market PFIC Stock

Distributions from a PFIC under a mark-to-market election

This is a question we received through an email:

I own stock of a PFIC. I made a mark-to-market election for the PFIC stock. The PFIC made a distribution of cash during the year. How is the distribution taxed?

In this post, I will discuss why the distribution is mostly treated like a distribution from a normal corporation (with the exception that the dividend never can be a qualified dividend).

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. It applies to a foreign corporation if it satisfies either:

  • An income test: 75% or more of its gross income is passive income, or
  • An asset test: 50% or more of its gross assets produce passive income or are held for the production of passive income.

There are 3 ways income from a PFIC is taxed to a US person:

  • Under default rules (without any election);
  • Under a qualified electing fund (QEF) election; or
  • Under a mark-to-market (MTM) election

In this post, we assume that the US person has made a MTM election for the PFIC stock he owns.

MTM election results in deemed sale of stock annually

When a taxpayer makes a mark-to-market election for a PFIC stock, there is a deemed sale of the stock at the end of every year. IRC §1296(a).

Code section 1296 and the underlying regulations go into detail about how the deemed sale affects income and basis, and how an actual sale of the MTM stock is taxed. Because this post is concerned about distributions from the MTM stock only, I will not go into details about how the deemed sale works.

What Code section 1296 and the underlying regulations conspicuously leave out is any discussion about taxing distributions from the MTM stock.

Distribution: Dividend, return of capital, or gain

Neither the Code nor the regulations for the MTM election says how distributions are taxed. But we can make a deduction.

Proposed regulations 1.1291-2 and 1.1291-3 contain how PFIC distributions and gains are taxed under the default rules. By the terms of the proposed regulations, the default rules apply to “1291 funds”. Prop. Treas. Reg. §§1.1291-2(a), -3(a). Or, to put it another way, if the PFIC stock is not a 1291 fund, then the default rules do not apply.

This is how the regulations define a 1291 fund:

A PFIC is a section 1291 fund with respect to a shareholder unless the PFIC is a pedigreed QEF with respect to the shareholder or a section 1296 election is in effect with respect to the shareholder. Reg. §1.1291-1(b)(2)(v).

The 1296 election is the MTM election. Our PFIC stock is under a MTM election, so it is not a 1291 fund. Therefore, the default rules for distributions from a PFIC do not apply.

Without a special rule for distributions from MTM stock, we are left with the general rules for distributions under the Code: section 301. The distribution is a dividend up to the PFIC’s earnings and profits, a return of capital in excess of earnings and profits and up to the shareholder’s basis, and a gain in excess of basis. IRC §301(c).

The dividend is probably ordinary dividend

Qualified dividends are taxed at long-term capital gain rates. IRC §1(h)(11). Ordinary dividends are taxed at ordinary income tax rates. A PFIC cannot distribute a qualified dividend, so any dividend that the shareholder receives is an ordinary dividend. IRC §1(h)(11)(C)(iii).

Making the MTM election means that the owner does not treat the MTM stock as a 1291 fund, so he avoids the default rules for PFICs, but nothing in the PFIC rules suggests that the MTM stock stops being treated as PFIC stock. Therefore, the MTM stock is PFIC stock. This means any dividend it distributes is an ordinary dividend.

The gain is ordinary income

Any gain from the sale of a MTM stock is ordinary gain. IRC §1296(c)(1)(A).

If you receive a distribution from a corporation in excess of its earnings and profits and your basis, then the excess is treated as gain from the sale of your stock. IRC §301(c)(3)(A). Under the MTM rules, the gain is ordinary gain.