PFIC distributions and Net Investment Income TaxApril 21, 2016 - Debra RuddPFIC and CFCs
Hi from Debra Rudd.
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PFIC distributions and Net Investment Income Tax
Today I’m going to talk about a question I’ve received from a few different people. This particular version of the question comes from reader X:
Does the Net Investment Income Tax apply to the entire distribution I receive from my PFIC? Since some of the distribution is not included in income, I have heard many people say that a portion of the distribution should not be subject to the Net Investment Income Tax. Do you know how this works?
X’s question can be answered by addressing the following three separate questions:
- What is the Net Investment Income Tax?
- How are PFIC distributions taxed, and what does X mean when he says a portion of the PFIC distribution is not included in income?
- How does the IRS apply the Net Investment Income Tax to PFIC distributions?
What is the Net Investment Income Tax?
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’s ignore the term “Modified Adjusted Gross Income” and just assume that the NIIT does in fact apply to X.
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 question X wants to answer is: How does the NIIT get applied to PFIC distributions?
How PFIC distributions are taxed
First, let us examine what X means when he says that a portion of the PFIC distribution is not included in income, which requires a basic understanding of how PFIC distributions are taxed.
I will assume that X has not made any PFIC elections, so he is operating under the default excess distribution rules of IRC §1291.
When you receive a distribution from a PFIC, and your PFIC is taxed under the default rules, the very first thing you do is ignore the usual rule under IRC §301 that says that your distribution is either a dividend, a return of capital, or a capital gain (or some combination of those)
Instead, you must figure out: What portion of the distribution is an “excess distribution” under IRC §1291?
The amount you calculate to be the excess distribution is subject to a particularly harsh set of rules with very high tax rates and interest charges; the remainder of the distribution follows the normal rules of section 301.
Excess distributions: what are they?
I am not going to go into detail about how to calculate excess distributions in this post. If you would like to read about that, visit a previous post that dealt with that topic in detail.
For our purposes, just assume that of the total distribution X received, some portion of it is excess distribution and some portion of it is non-excess distribution.
The non-excess portion of the distribution is subject to the normal section 301 rule: it is either dividend, return of capital, or capital gain. The excess portion of the distribution is taxed in a special way.
Excess distributions: how are they taxed?
Once you have computed your excess distribution, you have to allocate the excess distribution over each day of your holding period, ending with the date of the distribution.
You then assign each day to one of the following periods, and add up the amount of excess distribution allocated to each period. The amounts allocated to each period are taxed as follows:
- Pre-PFIC period: ordinary tax rates.
- Prior years PFIC period: maximum individual tax rate for each year in the period plus a daily compounded interest charge.
- Current year: ordinary tax rates.
The important piece of information to take away from this is that your excess distribution is allocated to different time periods, and the amounts allocated to those different time periods are taxed in different ways.
Excess distributions: amounts “not included in income”
The excess distribution allocated to the prior years’ PFIC period is subject to a special tax and interest calculation.
That special calculation involves dividing the amount allocated to the prior years’ PFIC period up by tax year, applying maximum individual tax rates to the amount allocated to each year, and applying an interest charge to the tax computed for each year.
Because X is computing the tax and interest directly on the prior years’ PFIC period, those changes do not get included in his income on his tax return. Instead, it is added directly into the tax X pays on page 2 of his Form 1040.
The amount allocated to the current year, however, is included in income, and X pays tax on it at his marginal rate.
X’s question was whether the NIIT applies to the amount allocated to the prior years’ PFIC period, because that amount is not included in income.
This is not an unreasonable question. After all, section 1411 (the Code section that imposes NIIT) specifically defines net investment income to be the sum of certain types of gross income and net gain.
NIIT on PFIC distributions
The Treasury Regulations say something different, however.
For purposes of computing NIIT, ignore all of the computations just discussed for the PFIC distribution. You still do those computations, and the PFIC is still taxed the way I described above, but that doesn’t matter for NIIT.
Instead, the NIIT is applied to amounts that constitute dividends under IRC §316. Regs. §§1.1411-4(a)(1)(i) and 1.1411-10(c)(1)(ii).
IRC §316 says that a distribution is a dividend if it is paid out of current or accumulated E&P.
X simply has to look at the total distribution he received for the year and determine whether any or all of the distribution was paid from current or accumulated E&P. If the answer is “yes”, that amount is a dividend for NIIT purposes and must be included in the NIIT calculation.
If any portion of the dividend for NIIT purposes is not included in income and therefore does not auto-populate on Form 8960 (where NIIT is calculated) in the software he is using, X should use line 6 of Form 8960 to make an adjustment so that NIIT will be computed correctly.
The NIIT regulations do not make any special provisions for the portion of an excess distribution that is not included in income, which tells us that Congress did not intend for us to be able to exclude a portion of the distribution from NIIT based on the theory that its tax was computed outside the normal tax rules.
Indeed, the Form 8960 Instructions indicate that if there is an amount that was not included in your taxable income from a PFIC but should be subject to NIIT, then you are responsible for making the manual adjustment so that NIIT does include the correct amount.
Recap: NIIT for PFIC distributions
When determining whether NIIT applies to your PFIC distribution, ignore all the PFIC computations you are required to do for Form 8621. You still do those computations, and you still file Form 8621 and pay the tax and interest, but that does not determine the NIIT you pay.
Simply look at whether the entire distribution or any portion of it constitutes a distribution from current or accumulated E&P and would be taxed as a dividend if not for the PFIC rules; if so, that amount is subject to NIIT.
As always, thank you for reading. You absolutely should not rely on this as advice; make sure to hire a professional if you need help.