Let’s take a common situation: you are a U.S. citizen living abroad, married to a non-U.S. citizen. You buy mutual funds for investment, because that’s what sane people do when they invest their money. These are foreign mutual funds because, after all, you live abroad.
What happens if you give those foreign mutual fund shares to your non-U.S. citizen spouse?
Hilarity ensures. If by “hilarity” you mean paying income tax AND gift tax on a gift of mutual fund shares to your spouse.
The Usual Rule: No Income Tax on a Gift
The usual rule is that a giver does not pay income tax when making a gift. There is a simple reason for this: the giver received nothing in return. When you think of income tax, you think of the in
and everything is going out
when you make a gift.
The recipient of a gift does not include the value of the gift in income.2
Gift tax might apply. Let’s ignore this for the moment.
But Not for PFICs: Gifts Trigger Income Tax
The usual rule does not apply to PFICs–shares of foreign mutual funds. Giving away shares of a PFIC will (except in a few exceptions – there are always
exceptions in tax law) cause you to pay income tax:
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. Proper adjustment shall be made to the basis of any such stock for gain recognized under the preceding sentence.3
The Treasury Regulations are where we look to see exactly how this works. Proposed Regulations Section 1291-6 is the place to go. Gifts are specifically called out as taxable4
even though the gift would otherwise not trigger income tax.5
PFIC Income Tax: How To Calculate
The way to calculate the income tax on your gift of foreign mutual fund shares is simple: it is a “disposition”6
and taxed accordingly.7
Unless an exception applies, the gain taxed under the “excess distribution” rules.8
The excess distribution rules say to take the total gain on disposition9
and allocate it across all of the years that you owned the foreign mutual fund shares. The part allocated to this year gets taxed the normal way. The part allocated to earlier years? Compute the income tax on that using the highest
tax bracket that existed each year, not the actual tax bracket you were in. Then, for added pleasure, pay interest to the IRS on all of the tax you computed for those earlier years..
No PFIC Income Tax: Exceptions
Yes there are exceptions. I will write about them another day. But just briefly mentioned, they are:
- If the PFIC was a QEF fund;10 or
- You gave the PFIC shares to a U.S. citizen or resident alien11 or a nonresident alien spouse who has elected to be taxed as a U.S. taxpayer.12
Pay Gift Tax, Too
But wait, there’s more! If you give PFIC stock you will pay income tax
(plus interest) for the privilege of making the gift. But you will also be making a taxable gift as defined in the gift tax section of the Internal Revenue Code, so you can potentially pay gift tax
I am keeping the email short this week (half as long as usual) so I will spare you the gruesome details but just point you to the fact that the Proposed Regulations have examples in them where gift tax and PFIC-driven income tax are both payable.13
And remember how I said that you don’t pay the PFIC income tax on gifts of PFIC shares to a U.S. taxpayer? Yeah, I kind of lied. If you make such a gift and you pay gift tax, you will have to pay the PFIC income tax on an amount of income equal to the gift tax you paid.14
This week’s pre-emptive strike against blamethrowers arrives as bad haiku:
- Not legal advice.
- Find someone who knows PFICs.
- The solution comes.
See you next Friday.
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