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September 18, 2011 - Phil Hodgen

How gain on disposition of a PFIC is taxed

Let’s say you own PFIC stock.  (Hint:  foreign mutual funds almost certainly are PFICs.  So even normal people can own PFICs, to their absolute horror.)

You sell your PFIC stock.  Better yet, you sell at a profit.  “Buy low, sell high!”  How hard can that be?  🙂  To make this example extremely simple, I am going to assume that you bought and sold the PFIC stock in a single calendar year, and that the PFIC never paid you a dividend (a “distribution” in PFIC jargon).

How will you report your gain on disposition of the PFIC stock on your tax return?  Is this capital gain or ordinary income?

Answer:  it depends.  I’m going to show you the default method here.

There are three ways that PFIC stock sales are taxed.  You will be shackled to using the default method unless you made a “mark-to-market” election or a “QEF” election.  If you don’t know what those words mean, then you probably didn’t make those elections and you are forced to use the default method described here.

If you use the default method, the Internal Revenue Code uses the phrase “section 1291 fund” to describe your PFIC.  So if you see this phrase on Form 8621 or in the Instructions to Form 8621, now you know what that means.

How much gain is taxed?

If you have a PFIC and you have a disposition, you first have to figure out “Do I have a gain or loss?” according to the normal rules of the Internal Revenue Code. The normal “sales price minus basis” stuff applies.  So let’s assume you have gain.  (Tax buffs call this “realized” gain.  You have income that is theoretically subject to tax, unless you can find a way out of being taxed.)

Now that you know you have realized gain, you have to figure out whether the gain is recognized.  (This is tax insider jargon for “the income you received is going to go onto your tax return and tax will be imposed.”)  The default assumption of the Internal Revenue Code is that all realized gain will be recognized, unless you can find an explicit exception that applies to you.

These explicit exceptions are called “nonrecognition” provisions in the Internal Revenue Code.  Let’s just assume (to make my example easy) that all of your profit from “buy low, sell high” will be recognized.

Ordinary income or capital gain?

At this point we know the gain on sale of your PFIC stock will be taxable.  We just don’t know whether it will be capital gain (you owned some stock as an investment, and you sold it) or as ordinary income.

The default PFIC taxation rule is in Section 1291.  It is called the “excess distribution” rule.  It flatly states that gain from disposition of PFIC stock will be taxed as if it is an “excess distribution.”  See Section 1291(a)(2).  So now we have to know how an “excess distribution” is taxed.

Again, Section 1291 helpfully (!) hardwired the answer to that question for us.  An “excess distribution” is taxed as ordinary income.  See Section 1291(a)(1)(B).

Put it on Form 8621

Dispositions of PFIC stock are reported on Form 8621.  You will be filing Form 8621 along with your tax return.  Here is how you do it:

• First, fill in the top part of Form 8621, page 1.  This is where you put your name and address and all that fun stuff.
• Second, in Part I, don’t do anything.  You are doing a simple sale of the PFIC stock using the default rules.  You didn’t make any elections.
• Part II does not apply to you.  It would only apply if you had made a Qualified Electing Fund election.  We assume you did not.
• Part III does not apply to you.  You did not make a Mark-to-Market election.
• Part IV is where all the guts and glory reside.  For you, at least.  Lines 10a through 10e will not apply.  Our example deals with gain on a disposition only.
• At Line 10f, enter the gain you recognized on the sale of your PFIC stock.
• At Line 11a, prepare the statement that is requested and staple it to the back of your tax return.
• At Line 11b, take the amount of gain that is allocable to the current year (the year you’re doing your tax return for) from the statement you just made, and write in the number.  In our example, you bought and sold the PFIC stock in the current year, so all of the gain is reported here on Line 11b.  (Pro tip:  in my example, the amount on Line 10f is the same as the amount on Line 11b).
• Line 11b tells you to report the number shown on Line 11b as “other income” on your Form 1040.  For the 2010 version of Form 1040, this is line 21.
• Lines 11c, 11d, and 11e are all blank.
• Part V doesn’t apply to you, because you never made any elections as to this PFIC.

Ta-DAH!  You’re done.