This week’s episode of the Friday Edition is brought to you by the letter “S”, as in Singapore, where last weekend I met with a group of 30 entrepreneurs–mostly U.S. citizens living and running businesses outside the United States. They have an actual or lurking problem that they do not see: normal businesses that look to the IRS like they are Passive Foreign Investment Corporations.
The Passive Foreign Investment Corporation and Controlled Foreign Corporation rules are the government’s countermeasures against a logical tax strategy–tax deferral.
If your business operates through a foreign corporation … you probably have a latent Passive Foreign Investment Corporation on your hands, or (“less bad”) you probably have a Controlled Foreign Corporation.
Why PFIC and CFC Rules Exist
The Controlled Foreign Corporations and Passive Foreign Investment Corporations rules exist because:
- Uncle Sam wants you to pay tax now, and
- You want to pay tax later.
Postponing the payment of tax (indeed, any debt) has economic value.
Pretend you earn $500 of income, and owe $100 of tax on that income (a tax rate of 20%). You find some way to legally tell the IRS “I will pay you $100 next year year, not today”. You take the $100 and invest it, earning a 10% return in one year. At the end of the year you have $110: the $100 that you must pay to the IRS for last year’s tax, and $10 that you earned this year by investing that $100.
You pay the $100 of tax that you owed. That leaves $10 in your pocket (the investment earnings). You pay 20% tax on the $10 of investment earnings, leaving $8 in your pocket. That $8 in your pocket is free money, created because you were able to postpone the payment of your tax by a year.
The government’s countermeasures fall into two categories:
- Make it expensive. You must pay interest or penalties (or both) if you do not pay your tax when the IRS thinks you should pay the tax. The PFIC rules are an example of this.
- Make it difficult. Fictions are created to make you taxable now on income that would not otherwise be taxable now. The Subpart F and CFC rules are an example of this.
If you own shares of a Passive Foreign Investment Corporation, you have a choice. You can be taxed every year on the income generated inside that corporation.1 Or, you can postpone the day you pay tax. When you eventually take the income, you will be taxed at a higher (probably) tax rate, and you will pay interest on top of the tax you owe.2 That’s how the “make it expensive to postpone tax payments” countermeasure works.
If you own shares of a Controlled Foreign Corporation, and if the corporation earns income that the IRS does not like, then a legal fiction makes you taxable on that “bad” income (called Subpart F income by tax nerds). We pretend that you received the income, whether you actually did or not. That is how the “make it difficult” countermeasure works. The method you thought would work (earn money inside a foreign corporation) will not do what you want it to do.
Surprise! It’s a PFIC!
Consider a perfectly normal business, selling real services to real customers. Maybe it is a SaaS business. Maybe it provides consulting advice (SEO, copywriting, legal or accounting services, whatever) to customers. It operates through a foreign corporation, and you (a U.S. citizen or green card holder) are a shareholder.
Look at the foreign corporation’s assets. It has a MacBook Pro and a bank account. If the cash is worth more than the MacBook Pro, the foreign corporation is a PFIC. A foreign corporation is a Passive Foreign Investment Company if one (or both) of two things is true:
- 75% or more of its income is “passive” income; or
- 50% or more of its assets are “passive” assets.
The second item is called the “asset test”.3 My example says the corporation owns a MacBook Pro and a bank account. Let’s see how it is dreadfully easy for this corporation to be a PFIC.
Cash is a passive asset. Notice 88-22, 1988-1 C.B. 489 says:
Working capital. Cash and other current assets readily convertible into cash, including assets which may be characterized as the working capital of an active business, produce passive income, as defined in section 904(d)(2)(A). These assets are, therefore, passive assets for purposes of the section 1296(a)(2) asset test.
This is questionable logic. Corporations need cash to operate and generate operating profit, so any cash held for working capital should be viewed as an active asset. Looking at a foreign corporation’s cash, maybe some of the cash is not needed for working capital, so could be seen as a passive investment type of asset. But some of the cash, surely, should be treated as an active asset. Unfortunately, this is not the case. The IRS is the pit boss in Uncle Sam’s casino, and we must play according to the casino’s rules.
The implication is inescapable. If the foreign corporation’s bank account has more cash than the MacBook Pro is worth, the corporation is a Passive Foreign Investment Corporation.
Here are the workarounds I can think of. None are satisfactory.
Workaround Number 1: Accounts Receivable
Remember that the PFIC asset test requires the foreign corporation to have more than 50% passive assets. Accounts receivable are active assets. Notice 88-22 says:
A trade or service receivable derived from sales or service provided by the corporation in the ordinary course of its trade or business which produce nonpassive income will be treated as a nonpassive asset for purpose of the asset test.
Can you operate your business (inside a foreign corporation) so that the following formula is true? If so, your foreign corporation will not be a PFIC.
MacBook Pro + Accounts Receivable > Cash
You cannot do this forever. The implication of this formula is that you are creating accounts receivable faster than you are collecting from your customers. That’s a recipe for disaster–if you keep doing this, you will run out of cash and the business will die.
The reality is that sooner or later you collect the accounts receivable (active assets) and have cash (a passive asset). Your foreign corporation then becomes a PFIC.
Workaround Number 2: Timing
The second workaround depends on time. You measure your assets at the end of every calendar quarter, and compute the average to see if passive assets are more than 50% of the foreign corporation’s total assets.
This workaround means you carefully drain almost all of the cash out of the foreign corporation before the end of each quarter, so that the total cash in the foreign corporation’s bank account is less than the value of the MacBook Pro. Now the active business asset (your computer) is worth more than the passive asset (cash). Your foreign corporation is not a Passive Foreign Investment Corporation.
But look what happened. You took cash out of your foreign corporation (where it is possible to postpone the moment of taxation under U.S. tax law) and put it in your pocket (where it is taxable).
This does not work, either. You have done exactly what the IRS wants you to do: created income for yourself that is taxable now, rather than later.
Workaround Number 3: Goodwill
Goodwill or going concern value – these are intangible assets that have value. If you can say that the goodwill generates active business income, then the intangible asset is an active asset. It can be included on the balance sheet as a counterbalance to the cash asset, which is passive. Now the following equation must be true in order to avoid PFIC status for the foreign corporation:
MacBook Pro + Accounts Receivable + Goodwill > Cash
This workaround will not be sufficient for one simple reason. Are you going to go through the work and effort to do this? Probably not. Goodwill is usually valued based on one of a few methods: a multiple of cash flow; earnings before interest, taxes, depreciation, and amortization (EBITDA); or some other method in the same way that a buyer would value your business. The IRS has not issued Regulations blessing this process, so you have danger (if the IRS disagrees with you) and expensive accounting fees.
This is impractical for most digital nomads.
Effective Defense Number 1: Be a CFC
The defense to PFIC status that will work is simple. Make sure the foreign corporation is a “Controlled Foreign Corporation” and make sure you are a “U.S. shareholder”.
Internal Revenue Code Section 1297(d)(1) says:
For purposes of this part, a corporation shall not be treated with respect to a shareholder as a passive foreign investment company during the qualified portion of such shareholder’s holding period with respect to stock in such corporation.
Your “qualified period”4 is the time during which two things are
- The corporation is a “Controlled Foreign Corporation” (meaning more than 50% owned by U.S. shareholders); and
- You are a “U.S. shareholder” as defined in Internal Revenue Code Section 951(b) (meaning you own more than 10% of the stock of the foreign corporation).
Status as a Controlled Foreign Corporation is not the worst thing in the world. As long as the foreign corporation does not have “Subpart F” income (think passive income like rent, royalties, dividends, etc.) it can operate cleanly. The major problem with CFC status for the foreign corporation is the work and cost involved with preparing and filing Form 5471.
Effective Defense Number 2: Be a Disregarded Entity
A second defense to avoid PFIC status is to make a special election to have the foreign corporation be treated as a disregarded entity for U.S. tax purposes. A PFIC is a foreign corporation that has too much passive income or passive assets. By making the special election, the foreign corporation ceases to be a “foreign corporation” for U.S. income tax purposes, so it cannot be a PFIC.
This is done by making an election on Form 8832. Every year you file Form 8858 with your tax return to report what happened inside the foreign corporation, and you are currently taxable on this corporation’s income.
Good news: no PFIC risk. Bad news: no tax deferral.
The Cost of Clever
An American’s business abroad is burdened with the possibility of Controlled Foreign Corporation status (Form 5471), Passive Foreign Investment Corporation status (Form 8621), or disregarded entity status (Form 8858). Postponing the date on which tax is paid on foreign income is either impossible or costly.
My suggestion for you digital nomads out there? Know what you have so you can file the right paperwork on time and avoid penalties. Simplify your operating procedures to keep your accounting costs down. Preparing Forms 5471, 8621, or 8858 will be expensive, and tracking all of this stuff will distract you from day-to-day business. Don’t get clever. The economic benefit of tax deferral is probably not as high as the cost of accounting and distraction.
The Usual Disclaimer
Get good tax advice from someone who knows this stuff. Don’t get advice off the internet, at cocktail parties, or by talking to anyone in the Philippines on May 2, 2015 (hint: Pacquaio/Mayweather fight).
See you next Friday.
- There are three ways to do this. The easiest is to withdraw money
from the corporation. The other two are methods built into the tax law
– the so-called “QEF Election” and “Mark to
Market” methods of taxation for PFICs. ↩
- This refers to the “excess distribution” rules for how
PFICs are taxed. ↩
- Internal Revenue Code Section 1297(a)(2). ↩
- Internal Revenue Code Section 1297(d)(2). ↩