Hi from Debra Rudd.
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I received the following question from reader S after writing about the Net Investment Income Tax in the context of PFIC distributions:
Along the same lines, if you were doing a deemed sale to remove the PFIC taint, would the gain from the sale still be subject to the NIIT? It’s not an actual sale as nothing was sold, but the taxpayer does get an uplift in basis for the deemed sale. I’m thinking it would be, but would appreciate your opinion.
I think S is right about this.
In today’s newsletter, I will first talk about what the Net Investment Income Tax is. Next, I will take a look at what the regulations say about how to apply the NIIT to PFIC gains, and lastly, I will try to answer S’s question about NIIT in the context of gains that arise from a deemed sale.
The Net Investment Income Tax, or NIIT, became effective in January 2013 as part of the Affordable Care Act. It applies to taxpayers with Modified Adjusted Gross Income high enough to trigger the requirement (and there are different thresholds for different filer types). For our purposes, let us ignore the term “Modified Adjusted Gross Income” and just assume that the NIIT does in fact apply in the scenario S is describing.
NIIT is a 3.8% tax that is applied to your net investment income in addition to any other income tax that applies.
“Net investment income” means income items like interest, dividends, capital gains, rental and royalty income (and etc.), minus certain deductions.
The IRS has a web page that describes how this works in a little more detail.
The Treasury wrote a rule for how to apply NIIT to gains from PFICs:
Gains treated as excess distributions under section 1291(a)(2) are included in determining net gain attributable to the disposition of property for purposes of section 1411(c)(1)(A)(iii) and § 1.1411-4(a)(1)(iii). Regs. §1.1411-10(c)(2)(i).
When you have a gain on the disposition of a PFIC, the entire gain is treated as an excess distribution according to section 1291(a)(2), which means the entire gain is included in your net gain from disposition of property for NIIT purposes.
That is easy enough for a real sale where you exchange PFIC stock for money. What about gains from pretend sales?
There are at least a couple different situations in which a taxpayer will have to recognize gain from the pretend sale of a PFIC. One is the situation S mentioned, where you make a deemed sale as a purging election to remove the PFIC treatment. There are others, too.
In all deemed sale situations, you are pretending that you sold the PFIC and reporting the gain (if any) on the sale, but you receive no sale proceeds and you retain ownership of the PFIC stock.
For NIIT purposes, a gain from a deemed sale would work the same way that a gain from a real sale would. Look at the language of Regs. §1.1411-10(c)(2)(i): “Gains treated as excess distributions” are subject to NIIT.
Both gains from real sales and gains from deemed sales are treated as excess distributions. The regulations do not make any exception to the rule for deemed sales. We should infer that the gain from a deemed sale is subject to NIIT in the same way that a gain from a real sale is subject to NIIT.
When you make a deemed sale of a PFIC to purge the PFIC status, you get to adjust your basis in the PFIC up by the amount of the gain you report.
Pretend you buy a PFIC for $10, make a deemed sale when it is worth $20, and then later sell it for $40. When you sell it for $40 you are reporting a $20 gain.
Applying NIIT to the gain from the deemed sale is consistent with getting an increase in basis.
S did not ask about this, but it is an interesting question, so I will talk about it anyway. :)
The NIIT rule for PFIC gains is relatively simple. The gain from any sale, real or pretend, is subject to NIIT.
Losses from a deemed sale, however, are not always recognizable. For example, when you are making the deemed sale as part of a purging election, no losses are allowed. That means you do not report a loss on your tax return, and your basis in the PFIC stock does not adjust down for the deemed sale loss.
My guess would be that you would not include a PFIC loss in the NIIT computation when you do not get to recognize that loss and you do not get a basis adjustment for that loss.
In a situation where you have a loss on a deemed sale for purposes other than purging elections (for example, if you are a covered expatriate who has to pretend you are selling your worldwide assets), you do get to recognize the loss on the sale. Again, this is just a guess, but I would guess that in those situations you would get to include the loss in your NIIT computation.
Gains from the sale or deemed sale of a PFIC are always subject to NIIT.
For losses, it is most likely the case that you have to look at the specific rule that governs whether you can recognize the loss or not — if yes, include it in your NIIT computation. If no, do not include it in your NIIT computation.
Thank you for reading. I will see you in two weeks with another exciting edition of PFICs Only.
Oh, and… You would be crazy to rely on this as advice. 🙂 So please, do yourself a favor and hire someone competent before making any life and/or tax decisions.