PFIC bought and sold in the same year – excess distribution rules

A question from a commenter triggered this blog post. Keep those questions coming!

Facts

A taxpayer buys shares of a PFIC for US$1,000 and sells them in the same calendar year for US$1,500. How is the US$500 gain taxed? How is it reported on a tax return? To keep this example simple, let’s pretend that there are no distributions or dividends from this PFIC. It is a simple buy low, sell high transaction.

Three methods of taxing PFIC gain

Dispositions of PFICs are taxed according to the rules in Internal Revenue Code Sections 1291 through 1297. For us, that is the Source of Ultimate Truth.

There are three methods by which PFICs are taxed:

• The “excess distribution” method;
• The “QEF election” method; and
• The “mark-to-market” method.

Default: use the excess distribution method

We start with the general rule for PFICs: use the excess distribution method unless you can find an exception. Section 1291(a)(2) says:

If the taxpayer disposes of stock in a passive foreign investment company, then the rules of [Section 1291(a)(1)] shall apply to any gain recognized on such disposition in the same manner as if such gain were an excess distribution.

This is important! Notice that Section 1291(a)(2) says that if there is a disposition of PFIC stock, then you treat the gain as an “excess distribution” and apply the rules of Section 1291(a)(1). Section 1291(a)(2) does NOT say “treat this as disposition of a capital asset and report the gain as capital gain.

OK. Remember that. When you sell your PFIC stock, your gain is an “excess distribution” and taxed as such, until you can find a reason to have it taxed in some other way.

How PFIC excess distributions are taxed

So how is a PFIC excess distribution taxed? Go look at Section 1291(a)(1), or to be more precise, read it and weep:

(1) Distributions. If a United States person receives an excess distribution in respect of stock in a passive foreign investment company, then–

(A) the amount of the excess distribution shall be allocated ratably to each day in the taxpayer’s holding period for the stock,

(B) with respect to such excess distribution, the taxpayer’s gross income for the current year shall include (as ordinary income) only the amounts allocated under subparagraph (A) to–

(i) the current year, or

(ii) any period in the taxpayer’s holding period before the 1st day of the 1st taxable year of the company which begins after December 31, 1986, and for which it was a passive foreign investment company, and

(C) the tax imposed by this chapter [26 USCS §§ 1 et seq.] for the current year shall be increased by the deferred tax amount (determined under subsection (c)).

Let me interpret that for you. Remember that when you sold that PFIC you made a gain, and it is taxed as an excess distribution. Here’s how it works:

1. First, you allocate the gain across the time you hold the PFIC, day-by-day. [Section 1291(a)(1)(A)].
2. Then you treat the amount of that excess distribution as ordinary income if it is allocated to the current year. [Section 1291(a)(1)(B)(i)].
3. In addition you treat any of the income allocated to 1985 or earlier as ordinary income, but we don’t care about that for the purposes of this delightful little literary escapade I am writing for you. [Section 1291(a)(1)(B)(ii)].
4. Finally you take the current year income tax that you calculated, and add some more tax to it, according to the calculation rules of Section 1291(c). [Section 1291(a)(1)(C)].

Remember that you bought and sold this PFIC stock in a single calendar year. That means that allocating the gain day-by-day across the holding period is not necessary since all of the gain was recognized in the current calendar year. That’s #1 above.

And all of the gain is treated as an excess distribution, and thus is ordinary income to you. That is #2 above.

We don’t care about point #3 above, because we’re assuming you bought the PFIC stock and sold it in a single year, and we don’t believe that time travel to 1985 is possible.

Finally (and trust me on this) you don’t worry about the additional tax due according to Section 1291(c). There is none–you will only have this when your holding period spans two or more taxable years. That’s point #4 above. Irrelevant in our case.

Where to report this on Form 8621

Gain from sale of a Section 1291 fund (that’s what you have here) is reported on Line 10f of Form 8621. The instructions to Line 10f note that the gain is taxed as ordinary income.

Line 11a is done by attaching a statement showing the holding period and the allocation of the gain across the days you owned the PFIC stock. In the case we are talking about, this will be simple. It really doesn’t matter. E.g., you will report that you bought the PFIC stock on March 15 and sold it on October 12. The entire holding period is within the current calendar year and you’re simply documenting this for the IRS.

Line 11b is the amount of the gain from sale of your PFIC stock that is allocable to the current tax year. The answer is “All of it.” So Line 11b will be the same as Line 10f.

The amount on Line 11b is then taken and put onto Form 1040 on page 1, on the “other income” line. For the 2010 Form 1040, this is Line 21.

And you’re done.

Are there no exceptions to this outcome?

Remember that I said there are three ways in which PFICs are taxed. I just walked you through the default method–the “excess distribution” method. What about the other two–the QEF election method and the mark-to-market method?

Hah. You’ll have to wait. This blog post is long enough.