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This week’s topic is inspired by a number of questions I received while delivering a speech on PFIC purging elections at the CalCPA International Tax Conference in San Francisco on November 06, 2015:
Jill is a US citizen who purchases an interest in a domestic publicly traded partnership in 2014. The partnership invests in various domestic and foreign companies. On Jill’s 2014 K-1, one of those foreign companies is shown as a PFIC with QEF income information provided. On her 2015 K-1, the company that was shown as a PFIC in 2014 has a note stating that it is no longer a PFIC, and no QEF income information is provided. What does Jill need to do on her 2015 US income tax return?
In today’s newsletter, I will discuss how the QEF election works when a PFIC is held through a domestic pass through entity. Then I will take a look at the rules for reporting income from a QEF that ceases to meet the PFIC definition.
A qualified electing fund (QEF) is a PFIC for which a valid QEF election has been made. Under the QEF rules, a PFIC is taxed similarly to a partnership, meaning that income retains its character (capital gains are taxed as capital gains) and is passed through to the shareholder for current inclusion in income.
You will pay less tax under the QEF rules than you will pay under the punitive Mark to Market rules of IRC §1296 or the extremely punitive excess distribution rules of IRC §1291. You will want to make the QEF election if you can because it has the best tax result for a PFIC.
For PFICs held through pass through entities, the QEF election is generally made by the first US person in the chain of ownership. Regs. §1.1295-1(d)(2).
For a PFIC that is owned by a domestic partnership, an interest in which is owned by a US citizen, the first US person in the ownership chain is the domestic partnership. The domestic partnership makes the QEF election. Regs. §1.1295-1(d)(2)(i)(A).
Under Regs. §1.1295-1(b)(3)(iv)(A), the QEF election is only valid for the partners if the election is made by the partnership:
Stock of a PFIC held through a pass through entity will be treated as stock of a pedigreed QEF with respect to an interest holder or beneficiary only if—
(A) In the case of PFIC stock acquired…and held by a domestic pass through entity, the pass through entity makes the section 1295 election…
Note that the QEF election is in effect “only if” the partnership makes the election. Jill cannot herself decide whether to make the QEF election — that is decided at the partnership level.
When she receives the 2014 K-1 from the partnership which provides QEF income information, Jill can assume that the partnership has correctly made a valid QEF election for the PFIC and that she must report it on her tax return as QEF income as directed by the K-1.
PFIC status for a corporation is determined by applying the income test and asset test under IRC §1297(a): if 50% or more of its assets are passive, or if 75% or more of its income is passive, then it is a PFIC.
According to Regs. §1.1295-1(c)(2)(ii), a shareholder of a QEF that ceases to meet either one the two tests does not include income under the QEF rules on her tax return.
That is Jill’s answer: the K-1 states that the company is no longer a PFIC, so she does not have to report income under the QEF rules for that company. When preparing her 2015 tax return, she can assume that any includable income from the former QEF (if there is any) is reflected elsewhere on the K-1.
In general, if a company is a PFIC in any year, it continues to be taxed as a PFIC in all future years, regardless of whether it meets the income test or the asset test in those future years. The only way that PFIC status can be terminated is by making a purging election to remove the PFIC status. IRC §1298(b)(1). This is known as the “once a PFIC, always a PFIC” rule.
However, there is an exception for QEFs in that paragraph:
Stock held by a taxpayer shall be treated as stock in a passive foreign investment company if, at any time during the holding period of the taxpayer with respect to such stock, such corporation (or any predecessor) was a passive foreign investment company which was not a qualified electing fund. IRC §1298(b)(1).
In this scenario, Jill’s PFIC is a qualified electing fund, because the partnership made the QEF election, and Jill is bound by that election.
The “once a PFIC, always a PFIC” rule does not apply to Jill, and she can rely on the regulation that states there is no QEF income inclusion when a QEF ceases to meet the PFIC rules. That result is automatic: she does not need to make a purging election.
Under Regs. §1.1295-1(c)(2)(ii), if a QEF that ceases to meet the PFIC definition begins to qualify as a PFIC once again in a future year, the QEF election remains in effect and the shareholder is subject to the QEF rules for that future year (unless the election is somehow terminated or invalidated).
If Jill’s PFIC held through the partnership meets the income test or the asset test in some future year (and if the PFIC provides the partnership with the necessary QEF income information), the K-1 will once again reflect the QEF income information she needs to report on her US tax return.
In Jill’s situation, she received a K-1 which explicitly stated that a PFIC which was previously taxed under the QEF rules no longer qualifies as a PFIC. But what if the PFIC just disappears from the K-1? As several CalCPA International Tax Conference attendees pointed out, that is sometimes the case.
In that situation, I’m not sure what the answer is. It could be that the PFIC was sold by the partnership, or it could be that, like in Jill’s situation, the PFIC ceased to meet the PFIC definition. Or, it could be a third scenario: the partnership left an important note off the K-1 in error.
Personally, I would look at the K-1 for clues: does it include notes about other PFICs held in the same partnership, saying that they did not qualify as PFICs in that year? If so, perhaps the PFIC that disappeared without a note was sold. Does it include notes about other PFICs that were sold? If so, perhaps the PFIC that disappeared without a note ceased to be a PFIC in that year.
You may need to contact the partnership for additional information if you cannot determine what happened by process of elimination (I, for one, wouldn’t take anything for granted). Maybe if many people contact the partnership requesting clarification, the partnership will begin to provide better detail on its K-1s in future years. ☺
As always, thank you for reading. This is not tax advice to you, and you cannot rely on it as advice. I skipped over a lot of nuances for the sake of brevity and clarity. If you need help, hire a professional.
See you in two weeks.