# PFIC distributions and Net Investment Income Tax

### 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.