This is a question we received through an email:
I bought shares in a foreign mutual fund and sold it in the same year. I made a gain on the sale. I am sure the mutual fund is a PFIC. Do I have any excess distributions to report?
In this post, I will discuss why the gain probably is an excess distribution.
Passive foreign investment company (PFIC) is a specific classification under US tax law. When a US person owns shares in a PFIC, the US person is subject to extremely punitive tax and reporting rules. They are designed to discourage US persons from investing through foreign investment vehicles.
It is common (though not always) for mutual funds to be PFICs, even if they might not be organized as a company. For this post, let us assume that we already know that the mutual fund in question is a PFIC. We just need to know how the gain is reported and taxed.
When you do not make an election for a PFIC, the distributions from the PFIC and gains are subject to special rules under Code section 1291. Losses use normal rules.
Code section 1291 say 2 things:
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. IRC §1291(a)(2).
The total excess distribution with respect to such stock shall be zero for the taxable year in which the taxpayer’s holding period in such stock begins. IRC §1291(b)(2)(B).
The Code tells us 2 apparently contradictory things: Gains must be treated as excess distributions, but there is no excess distribution in the 1st year. How do we resolve this apparent contradiction?
When a person has an excess distribution from a PFIC, he allocates the excess distribution proportionately across all days in his holding period. IRC §1291(a)(1)(A). Excess distributions allocated to the current year is ordinary income. IRC §1291(a)(1)(B)(i).
If we have a gain from selling a PFIC in the 1st year, and the gain is treated an excess distribution, then the gain is ordinary income.
Nonexcess distributions are not subject to special rules. In most cases, this means the gain is a capital gain, specifically short-term capital gain.
If we have a gain from selling a PFIC in the 1st year, and the gain is not an excess distribution, then the gain is short-term capital gain. This affects the taxpayer’s net capital gain and loss for the year.
It also affects how you would report the gain on Form 8621: whether line 5(a) is 0 or the gain.
As far as I know, the IRS has not specifically addressed this question, but we can piece together a reasonable guess as to what the IRS thinks the right answer is.
Proposed regulation section 1291-2 addresses how to treat a distribution from a PFIC. Proposed regulation section 1291-3 addresses how to treat a disposition of a PFIC.
Section 1291-2 tells us that a nonexcess distribution is treated under general rules for corporate distributions, e.g. under section 301, regarding dividends, return of capital, and capital gains. Prop. Treas. Reg. §1.1291-2(e)(1).
Section 1291-3 does not say anything about nonexcess distributions. In fact, it says “gain is determined on a share-by-share basis and is taxed as an excess distribution as provided in §1.1291-2(e)(2).” Prop. Treas. Reg. §1.1291-3(a).
The omission of any mention from section 1.1291-3 suggests that the IRS does not believe it is possible for a gain from selling a PFIC to be treated as a nonexcess distribution, even if the taxpayer sold the PFIC in the 1st year.
This is consistent with the structure of Form 8621. Line 15e tells us to report excess distribution from the PFIC. Line 15f of Form 8621 tells us to report gains from the sale of the PFIC share. Line 16a then tells us “if there is a positive amount on line 15e or 15f (or both), attach a statement for each excess distribution and disposition.” Once we see a gain, we go directly to calculating tax on an excess distribution.
These circumstantial evidence suggest that the IRS believes gain from selling a PFIC is always an excess distribution, even if the PFIC were sold in the 1st year of the holding period.
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