Greetings from Debra Rudd.

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You are invited to a special event: International Tax Lunch tomorrow

This Friday, 10 July 2015 at 12:00 pm Pacific time, I will be giving a presentation about the basics of Form 8621 elections. I will cover Mark to Market and QEF elections, and specifically: who can make these elections, when they can be made, what rules apply if you want to make one of these elections after operating under the default rules, and guidelines for inbound immigrants. I will also talk about transitioning between different elections and the rules that apply in the IRS OVDP and Streamlined Procedures.

The presentation is free to attend either in person at our Pasadena office or by phone. If you attend in person, we’ll buy you lunch. You can sign up here.

Today’s topic: How does the MTM election work in the OVDP?

This is one of the items that I will be covering in tomorrow’s presentation, and it is something I have received a ton of questions about. Typically the question I receive looks something like this:

How does the Mark to Market election work in the years after the OVDP period?

The question is pointing to the modified Mark to Market election available to taxpayers who participate in the IRS Offshore Voluntary Disclosure Program. The rules work a little differently than you may expect both during and after the OVDP period.

This may come as a small surprise to those of you who read my recent newsletter which stated that it is almost impossible to make a retroactive MTM election. But it is true — there is a special procedure for using the MTM election retroactively. It applies only to participants in the OVDP.

I will talk about how the MTM election normally works, how it works for the years covered by the OVDP, and how it works in the years following the OVDP.

MTM election basics

First, a brief summary of how the MTM election works normally. You can find these rules in IRC §§ 1296(a) – (d) and the Regulations.

Taxation of MTM gains and losses

The Mark to Market (MTM) election requires you treat the year-to-year increase or decrease in fair market value of a marketable PFIC as an ordinary gain or, if you are allowed to recognize a loss, an ordinary loss.

Each time you recognize a MTM gain or loss, you also increase or decrease your basis in the PFIC by the amount of the gain or loss.

Unreversed inclusions

You can recognize MTM losses, but only up to the amount of “unreversed inclusions”.

Each time you recognize a MTM gain, you “include” that gain in income. Therefore, you increase the unreversed inclusions for that fund by the amount of income recognized.

Each time you recognize a MTM loss, you decrease income, thereby “reversing” the effect of inclusion of gain in the previous years when you look at the cumulative effect of the MTM fund on income over the years. Therefore, you decrease the available unreversed inclusions by the loss amount recognized for that fund.

If you have a MTM loss that exceeds the available unreversed inclusions, you only recognize a loss (and decrease your basis) in the amount of the available unreversed inclusions. The remaining loss is ignored for that tax year.

Think of the unreversed inclusion as a running total of the net effect each MTM fund had on income over the years. Unreversed inclusions are not transferrable from one fund to another.

Taxation of disposition gains and losses

If you have a gain on sale, the gain is ordinary. If you have a loss upon sale that is less than or equal to your available unreversed inclusions, the loss is ordinary.

If you have a sale with a loss in excess of unreversed inclusions, the loss up to the amount of unreversed inclusions is ordinary, and the amount that exceeds unreversed inclusions is a capital loss.

Why would I want to do that?

This may not sound like a particularly desirable method of taxation. You include unrealized gains in income and pay tax at ordinary rates rather than capital rates. Why would anyone want to do this?

The answer is that the alternative is worse. Under the default rules for PFIC taxation, you only have to recognize income when there is a distribution or disposition, but you apply maximum tax rates (rather than ordinary) to a portion of the gain and add a daily compounded interest charge on top of that. The remaining portion of the gain is taxed at ordinary rates. This is clearly worse than the MTM election because there are higher tax rates and interest charges.

You will prefer to use the MTM treatment if you can because it will usually result in a lower tax.

Retroactive MTM elections are rare

The MTM election generally cannot be made retroactively. Regs. §§ 1.1296-1(h)(1)(i) and (iii).

To make a retroactive election, you must request permission from the IRS in the form of a letter ruling.

For permission to be granted, two requirements must be met.

First, you must demonstrate that you failed to make the MTM election because an IRS employee or tax professional gave you bad advice or because your own good faith application of the laws somehow led you astray (or that something on the level of a natural disaster prevented you from doing it). Regs. § 301.9100-3(b)(1).

For most people, the reason they did not make the MTM election is that they either did not know they had a PFIC or did not know about the MTM election. Those situations generally do not qualify you for late election relief, although it may be possible in the case where you relied entirely on a tax professional and they had all the necessary information about your PFICs but still advised you incorrectly. But most often, the scenario I see is that the taxpayer simply doesn’t tell the tax preparer about a PFIC because they don’t know they need to, and the tax preparer doesn’t know about the PFIC because they weren’t told about it. That scenario won’t qualify you for a late election.

The second requirement for the retroactive election is that you also must show that the IRS will not be prejudiced by granting the late election. The IRS is prejudiced if you end up paying less tax as a result of their decision. Regs. § 301.9100-3(b)(2). It is very possible you will end up paying less tax under the MTM election than you would under the default rules, so even if you otherwise met the requirements for the retroactive election, you may fail this requirement.

The practical result of these requirements is that a retroactive MTM election is not available to most taxpayers. And if you do qualify for the retroactive MTM election, you have to apply for a letter ruling and pay the user fees. Between paying the user fees and paying a professional to write the request for you, it may be financially impractical to do this.

TL, DR: I never see anyone apply for the retroactive MTM election.

Special rule for OVDP

There is, however, a special retroactive application of the MTM rules that is available to taxpayers who are participating in the OVDP. This application appears to have arisen purely as a matter of practicality.

The OVDP covers an 8 year tax return period. That means, to properly report your foreign investment income, you must obtain 8 years of bank statements. Most people have difficulty obtaining 8 years of bank statements. People with PFICs subject to the default rules of IRC § 1291 must obtain even more information in many cases: they need a complete history of all the transactions related to each PFIC going back to the initial purchase of the fund. For taxpayers who invested in foreign mutual funds in the 1990s, or earlier, getting the requisite information may be simply impossible.

The IRS introduced the modified MTM rules as a practical measure to give taxpayers a way of reporting their income from marketable PFIC stock. The rules are detailed in FAQ # 10 of the Revised 2012 OVDP Frequently Asked Questions.

How the election works during the OVDP period

The MTM election works like this:

  1. You find the fair market value of the PFIC as of the last day of the last tax year prior to the first tax year covered by the OVDP. For mutual funds held in foreign investment accounts, this should be pretty easy, assuming you can access the bank statements.
  2. That number is your adjusted basis in the fund for the first year of the OVDP period.
  3. You then do the Mark to Market calculations and reporting for the first year and each of the 7 subsequent years.
  4. The Mark to Market gains are taxed at a rate of 20% for each year of the OVDP, with the exception of the first year, in which gains are taxed at 27% (the extra 7% is to help compensate for the fact that you aren’t paying the interest charges as would have been required under the default rules of IRC § 1291).
  5. Mark to Market losses may be taken as ordinary losses, but only up to the amount of unreversed inclusions accumulated during the OVDP period, and the tax benefit is limited to 20% of the loss you recognize.
  6. If you elect to use this treatment, you must use it for all PFICs you own (the IRS says all PFICs, but I assume they mean all PFICs that meet the marketable stock requirement of IRC § 1296(e) — for non-marketable stock this could be impossible because you may not be able to determine the market value at the end of each year).

How the election works after the OVDP period

FAQ # 10 also describes how the MTM election works in the years after the OVDP period. First, and most notably, you must reduce all your accumulated unreversed inclusions down to zero. You then pretend “as if [you] had acquired the PFIC stock on the last day of the last year of the voluntary disclosure period at its MTM value and made an IRC § 1296 election for the first year beginning after the voluntary disclosure period”. I would assume that means you can then begin to accumulate unreversed inclusions again as you recognize MTM gains each year.

However, the IRS says something in FAQ # 10 that I find to be a little confusing. The FAQ mentions that “MTM and/or disposition losses in any subsequent year” after the OVDP period will be treated as capital losses (emphasis is mine). That runs contrary to the statement that you should apply the rules of IRC § 1296 as if you had purchased the fund just after the end of the OVDP period.

If you apply the MTM rules as written in the Code, you are able to accumulate unreversed inclusions and take losses against ordinary income up to the amount of the unreversed inclusions. Only in the case of a loss on disposition that exceeds unreversed inclusions would the loss be capital.

So how are these contradictory statements reconciled?

Follow the law

OVDP FAQ # 10 is inconsistent and seems to contradict itself. It is also not law.

My take on this is that you should follow the laws as written by Congress, meaning you apply the MTM rules exactly as they appear in IRC § 1296. That means you get to accumulate (and use) unreversed inclusions.

Because you are agreeing to a modified Mark to Market application for the OVDP period, it seems logical to follow the imperative to zero out the unreversed inclusions at the end of that period. But from that point forward, I see nothing in the Code or Regulations that prevents you from taking losses as ordinary if you have accumulated the unreversed inclusions to allow it.

The IRS ends FAQ # 10 with the following bullet point:

For any PFIC investment retained beyond the voluntary disclosure period, the taxpayer must continue using the MTM method, but will apply the normal statutory rules of IRC § 1296 as well as the provisions of IRC §§ 1291-1298, as applicable.

Even with the contradictory statement I previously mentioned about losses, I would feel quite comfortable taking the position that unreversed inclusions can be accumulated and used in the post-OVDP period, and that losses up to the amount of unreversed inclusions can be taken against ordinary income.

My personal opinion? The language used is a little unclear because the FAQ in one place says that any losses in the subsequent year will be capital, and in another place says that losses in any subsequent year will be capital. The placement of the word “any” takes the effect of the statement from applying to one subsequent year and changes it to apply to all subsequent years. I suspect one of those uses of the word “any” must have been unintentional, and I suspect it is the one that contradicts the normal workings of IRC § 1296 that is wrong. It seems that the IRS intention is most likely to have the standard rules of IRC § 1296 apply once the OVDP period ends.

This is not tax advice

I am talking about areas of uncertainty and contradiction that exist in the IRS communications. Do yourself a favor and do not consider this tax advice to you. Everyone’s situation is unique, and you should consult with a professional if you want advice that is relevant to your specific situation.

See you tomorrow, I hope

I hope that you will be able to join me for tomorrow’s presentation. If not, I will see you next week with another exciting issue of PFICs Only.