Correspondent C (thanks!) read my prior blog post about how the excess distribution rule would treat recognized gain on a purchase and sale in the same year, and pointed me to Section 1291(b)(2)(B). Wouldn’t that seem to indicate that we should treat the gain as capital gain rather than ordinary income?

Fact recap

Remember we’re talking about the simplest of investments: buy PFIC stock and sell it in the same year, at a profit. We are assuming that there are no distributions–dividends, etc. For the example, let’s assume you bought the PFIC stock at $1,000 and sold at $1,500.

Is there gain recognized?

In order to determine the tax imposed on disposition of PFIC stock, you must first figure out the amount of gain recognized. In order to do that you figure out the amount of gain realized (according to the Internal Revenue Code, do you have something that is theoretically taxable?), then you figure out whether in fact that gain will be taxed–is the gain recognized?

Example: think of interest income. You buy a bond and you earn interest. You have realized interest income. But is it recognized (i.e., something on which you pay tax)? If it is a regular corporate bond, yes. The interest income is taxable. But if you bought a municipal bond, the answer is no–your income is not recognized because there is an exception that says interest on muni bonds is tax-free.

The same thing happens here. You bought PFIC stock at $1,000 and sold at $1,500. You have realized a $500 gain. The default assumption in the Internal Revenue Code is that this gain is taxable (i.e., recognized) unless you find a “nonrecognition” provision that make that gain not be recognized–i.e., not be taxable. You can see the nonrecognition provisions for PFICs in Proposed Regulations Section 1.1291-6.

Since we have an extremely simple fact pattern (by assumption), let’s assume that the entire $500 gain on disposition of the PFIC stock is recognized.

We now know how much is going to be taxed–$500. The big question is HOW is it going to be taxed?

PFIC gain on disposition is taxed as excess distribution

At first glance, logic would tell you that you have a capital asset (the PFIC stock) that you sold, so the gain should be capital gain. It should be short term capital gain because you didn’t hold the PFIC stock for a year. Logic would lead you astray.

The PFIC rules alter the character of the $500 gain. The gain is characterized as being an “excess distribution.” [Section 1291(a)(2); Proposed Regulations Section 1.1291-3(a)]. We are not dealing with a capital gain now. We are dealing with an “excess distribution.” Whatever THAT is. πŸ™‚

Excess distributions are taxed as ordinary income

If you have an “excess distribution,” it is taxed as ordinary income. [Section 1291(a)(1)(B).

What is an excess distribution?

The idea of an excess distribution is meant to capture and tax distributions by a PFIC. Think dividends paid to shareholders. Think distributions to you because you own some shares of a foreign mutual funds. You receive distributions every year. Are they ordinary income or capital gain? The excess distribution calculation helps you figure that out.

The definition of an excess distribution is found at Section 1291(b)(1). I will deal with this in excruciating detail some other time. The idea is that you do some advanced math, subtracting the distributions you receive in a current year from a thing called the “total excess distributions” which is a term defined at Section 1291(b)(2).

And in the definition of “total excess distribution” there is a special rule that applies to the first year that you own a PFIC. It says that for that first year, the “total excess distribution” is defined as equal to zero. [Section 1291(b)(2)(B)].

At first you would think this applies to our little fact pattern and our quest to determine how the $500 gain on disposition of PFIC shares should be taxed. But in fact it doesn’t.

Section 1291(b)(1) is just the mechanism for looking at a particular dividend or distribution received, and determining whether it is an “excess” distribution or a “nonexcess” distribution. If you do the math and calculate that you have an excess distribution, then you hike off to Section 1291(a)(1)(B) and are told to tax that excess distribution as ordinary income. If you do the math and calculate that you have something that isn’t an excess distribution, then you are left to the general rules of the Internal Revenue Code to figure out how it’s taxed.

Disposition gain is defined as 100% excess distribution

But here we don’t care about calculating the excess distribution under Section 1291(b)(1). That’s because we are told–forced–to treat the whole gain on disposition as if it is an excess distribution. [Section 1291(a)(2)]. So the fact that Section 1291(b)(2)(B) says something about “total excess distribution” in year one as being zero will not matter.

Disposition gain always excess distribution; distributions not always

This conclusion is echoed in the Blue Book for the 1986 Tax Act, at page 1027:

This rule provides that all gain recognized on the disposition of PFIC stock must be treated as ordinary income. The portions of distributions that are not characterized as “excess” distributions are, of course, subject to tax in the current year under the general Code rules. [Emphasis added.]

(The Blue Book [warning! gigantic PDF!] is a God-awful thousand-plus page document written by the staffers of the Joint Committee of Taxation summarizing the changes of the 1986 Tax Act. The phrase “Blue Book” means the legislative summary of the tax laws passed in a particular Congress. There are a bunch of Blue Books. As long as we continue to elect people to Congress, we will continue to get more Blue Books.)


Disposition gain for PFICs is always going to be taxed as an excess distribution, therefore always ordinary income. Distributions from PFICs are subjected to the mathematics of Section 1291(b) to determine how much of the distribution will be deemed to be “excess” therefore ordinary income, and how much will not be characterized as “excess,” therefore taxed under one of the myriad of other rules in the Internal Revenue Code.