Hello from Debra Rudd.
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Is a late MTM election under the inbound immigrant rules possible?
This week’s topic comes from a question I received a while ago from an anonymous reader:
Does an immigrant to the US get to apply the basis step up/transition rule if they did not do a MTM election in their first year of US residence? Can we do it 2 years later?
The answer is “no”, but you can still make the mark-to-market election if you first make a pretend sale under the excess distribution rules. Because the immigrant has not been a US person very long, the actual tax result under the excess distribution rules may not be that bad, relatively speaking, and this could be a viable option.
In today’s newsletter, I will explain why a person new to the US may not use the inbound immigrant transition rule if they do not do it in the first year of US person status. I will then briefly describe the coordination rule for persons making the MTM election after operating under the excess distribution rules. Finally, I will use a specific example to show why the tax results of making the MTM election in the second year of US person status may be a viable option.
Inbound immigrant transition rule only for first year of US status
Our reader (let’s call him A) is referring to a special rule in the Code for inbound foreigners who own PFICs and who want to make a MTM election in the year in which they become US persons. This rule provides for a step-up in basis to fair market value at the beginning of the first year he is a US person (if that market value is greater than his adjusted basis in the PFIC) for the purposes of making the MTM election. IRC §1296(l).
The inbound immigrant transition rule is only available in the year that a person becomes a US person.
If the MTM election is not made in the first year of US person status, then the US immigrant is operating under the excess distribution rules of IRC §1291 for that year. IRC §1291 is the default treatment for PFICs when no elections have been made.
There is no provision for making a retroactive MTM election under the inbound immigrant transition rule.
A cannot make the MTM election under the transition rule two years after becoming a US person.
A can use the “coordination with section 1291” rule
Any person who is operating under the excess distribution rules can transition to the MTM election, assuming that their PFIC meets the marketable stock requirements of IRC §1296(e) and they are otherwise permitted to do so under the Code and regulations. Let’s assume that A owns marketable PFIC stock and is otherwise permitted to make the MTM election.
Under IRC §1296(j), coordination with section 1291 for first year of election, when A makes the MTM election in the second year of US person status, he is subject to a special set of rules that include gain recognition under the excess distribution rules:
- The entire first year of the MTM election, any distributions or actual sales are taxed under the excess distribution rules, not the MTM rules;
- At the end of the first year of the MTM election, A must make a pretend sale and recognize the gain under the excess distribution rules; and
- A does not get to operate under the MTM rules until the second year of his MTM election.
For a more detailed explanation of how this works, see a blog post I wrote last year on that topic.
Tax results under the “coordination with section 1291” rule
Let’s use the following scenario to determine the tax results if A makes the MTM election under the coordination rule of IRC §1296(j) in the second year of US person status:
A, a nonresident, purchases a foreign mutual fund which qualifies as a PFIC on January 1, 2008. A never makes any subsequent purchases or sales, and never receives any distributions from the fund.
A becomes a US resident under the substantial presence test in 2014, so the first day of A’s US person status is January 1, 2014.
A fails to make the MTM election under the inbound immigrant transition rule for 2014.
A decides to make the MTM election under the coordination with section 1291 rule for 2015.
A computes his gain on the deemed sale as of December 31, 2015 to be $1,000.
I will assume that readers are familiar with the excess distribution rules while going through the calculations. For those not familiar, go here for a primer in excess distributions.
Step 1: Allocate the gain over the holding period
The holding period is 8 years exactly, starting on January 1, 2008 and ending on December 31, 2015. Ignoring the extra day in leap years, A can allocate $125 of gain to each of the 8 years ($125 x 8 = $1,000).
Step 2: Separate holding period into pre-PFIC, prior years’ PFIC, and current year periods
Now we must separate the gains into three periods: the pre-PFIC period, the prior years’ PFIC period, and the current year.
The pre-PFIC period includes all the time that A was a nonresident of the US, according to Prop. Regs. §1.1291-1(b)(1)(i):
A corporation will not be treated as a PFIC with respect to a shareholder for those days included in the shareholder’s holding period before the shareholder became a United States person within the meaning of section 7701(a)(30).
Therefore, the amounts allocated to each period are as follows:
- Pre-PFIC period: From January 1, 2008 to December 31, 2013 (6 years). 6 x $125 = $750.
- Prior years’ PFIC period: From January 1, 2014 to December 31, 2014 (1 year). 1 x $125 = $125.
- Current year: From January 1, 2015 to December 31, 2015 (1 year). 1 x $125 = $125.
Step 3: Determine ordinary income
Under the excess distribution rules, the amounts allocated to the pre-PFIC period and the current year are ordinary income. That means in this example A has $875 of ordinary income.
Step 4: Calculate tax and interest on prior years’ PFIC income
$125 of the gain is allocated to the prior years’ PFIC period. Tax is computed on that amount at the maximum tax rate for the year. For 2014 that is 39.6%.
A’s tax on the amount allocated to 2014 is $125 x 39.6% = $49.50.
A must compute interest on the tax he calculated as if it was an underpayment of tax due on the tax return due date of the tax year to which the tax was allocated, and the interest runs through the due date of the tax return on which he is reporting the excess distribution. IRC §1291(c)(3).
For A, that means he computes interest on $49.50 of tax from April 15, 2015 to April 15, 2016. I calculated the interest to be $1.51.
Recap of tax results for A
To recap, if A makes the MTM election under the coordination with section 1291 rules in his second year of US person status, and computes his gain to be $1,000, the tax he will face will be the following:
- Ordinary income of $875, assuming a tax rate of 30% = $262.50
- PFIC tax and interest on amount allocated to prior years’ PFIC period = $49.50 + $1.51 = $51.01
- Total tax as a result of the election = $262.50 + $51.01 = $313.51
Some comments on this strategy
Note that, had A been able to make the MTM election under the inbound immigrant transition rule, the entire gain would have been ordinary income (and according to my calculations that means $13.51 less tax to pay, assuming a gain of $1,000).
Of course, he would have been able to use a stepped-up basis under the inbound immigrant transition rule, so the gain would have been smaller than the $1,000 we are dealing with here, and the tax savings could have been quite a bit more than $13.51.
However, I would like to point out that the interest charges only apply to one year of A’s holding period when using the method I described here, so he will at least not be subject to years upon years of accumulated interest.
While it is not the best tax result he could have had, it may be worth it to make the MTM election under the coordination with section 1291 rules if he plans to continue to hold the fund for a significant period of time and plans to continue to be a US person. In the long run, the MTM election will be better for him than the default PFIC treatment.
He can consider the extra tax he pays by failing to make the MTM election in the first year the “oops” tax. I personally pay an “oops” tax somewhat frequently in life because I am human and I make mistakes. 🙂
As always, thank you for reading this week’s edition of PFICs Only. I hope that you found something useful in it, but please do not rely on this as legal or tax advice (and hire a professional if you need help).
See you in two weeks.