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April 20, 2017 - Haoshen Zhong

PFIC Problems when Pooling Stock Reward

Pooling your stock reward

We got a fairly complex question about a US person pooled his stock reward with his coworkers. By doing so, the US person created a potential PFIC problem.

This post is a brainstorming session on how the US person might get out of his PFIC problems.

The scenario

Here is the scenario:

I am a manager of a private foreign business. In advance of an upcoming IPO, the private foreign business offered its managers the chance to buy shares in the top level parent corporation.

For the purpose of pooling our resources, the managers formed a foreign corporation (manager holding company) and bought shares of the parent corporation in the name of the manager holding company. I am the only US person among the managers. I hold a minority stake in the manager holding company.

When the parent corporation went public, the manager holding company dissolved and distributed its assets and liabilities to the managers. In the articles of dissolution, the manager holding company and managers agreed that all transactions that occurred will be deemed to have been conducted by the individual managers. Each manager picks up his or her share of liabilities and assets, income, and expenses of the manager holding company.

All transactions took place in one tax year.

I will add another assumption to this scenario: None of the entities in the foreign business in which our reader bought shares is a PFIC. This way, we do not have to worry about lookthrough rules for the parent corporation or any subsidiary corporations. We focus on the manager holding company only.

The manager holding company looks like a PFIC

A passive foreign investment company (PFIC) is any foreign corporation that meets either an income test or an asset test. IRC §1297(a).

  • Income test: 75% or more of its income is passive income; or
  • Asset test: 50% or more of its assets produce passive income or are held for the production of passive income

The manager holding company is a foreign corporation. Its only assets were cash and stocks in a foreign corporation. Cash can give rise to interest. Stocks give rise to dividends. Interest and dividends are passive income. And the capital gain from selling the stocks is passive income, because the stocks give rise to dividends. IRC §§1297(b), 954(c)(1)(A), (B)(i). Therefore, the manager holding company looks like a PFIC.

The CFC-PFIC overlap rule is not helpful

There is a special rule that says if you are a US person, you own at least 10% of the voting power of a foreign corporation, and the foreign corporation is a controlled foreign corporation (CFC), then you do not treat your shares in the CFC as PFIC shares. IRC §1297(d).

You can check for CFC status using the following test:

  • Look at all US persons who own at least 10% of the voting power in the foreign corporation.
  • Add up the shares of these 10% US voting shareholders.
  • If the sum of their shares is more than 50% of the total voting power, or the sum of their shares is more than 50% of the total share value, then the foreign corporation is a CFC.

Here, our reader is the only US person who owns shares in the manager holding company, and he owns a minority of the shares. Therefore, the manager holding company is not a CFC. The CFC-PFIC overlap rule does not apply.

Maybe the startup year exception applies

A startup exception for PFIC status exists. A foreign corporation can escape PFIC classification for a startup year if all the following conditions are true. IRC §1298(b)(2).

  • The foreign corporation does not have any predecessor that was a PFIC;
  • The foreign corporation (or a US shareholder) establishes to the IRS that the foreign corporation will not be a PFIC for the next 2 tax years; and
  • The foreign corporation is not a PFIC for the next 2 tax years.

This rule looks appealing, because if a foreign corporation liquidates in the first year of its existence, then of course it cannot be a PFIC in the next 2 years.

But we have to wonder whether it is worth using the startup year exception.

Our reader held the shares in the manager holding company for less than 1 year. If the manager holding company is a normal corporation, then the gain our reader realizes from the liquidation of the manager holding company is short-term capital gain. He pays ordinary income tax rates on the gain.

If the manager holding company is a PFIC, then the gain is excess distribution. IRC §1291(b). But because the manager holding company has existed for only 1 year, the entire excess distribution is ordinary income. IRC §§1291(a)(1)(B)(i).

Either way, the gain is taxed at ordinary income rates. The only advantage of using the startup year exception is to reduce the paperwork associated with PFICs.

Maybe the foreign corporation never owned the stocks

An interesting feature of this transaction is that the managers assumed all liabilities of the manager holding company during liquidation. This is an unusual step: Usually the shareholders of an entity with limited liability do not assume the entity’s liabilities upon liquidation.

Perhaps the managers really entered into an informal general partnership, with the manager holding company as the managing partner. A general partnership seems to describe the relationship between the parties fairly well: As an agent for all partners, the manager holding company can incur liabilities that bind the other general partners.

There are difficulties with this solution. For example, the managers did not, from the outset, assume liabilities of the manager holding company. And it is not clear that the creditors of the manager holding company could have sought damages from the shareholders without the liquidation agreement. In this respect, the arrangement is unlike a general partnership.

Then there are issues with formality. There is no general partnership agreement. The manager holding company does not hold itself as a partner in a partnership. And the manager holding company holds itself out as a company in which the manager own shares. The IRS may use the formal structure the manager holding company adopted against our reader.

And then there is the question of whether it is worth it to risk characterizing the arrangement as a general partnership. When a partnership distributes marketable securities, and the value of the securities exceed a partner’s basis in the partnership, the partner must recognize gain. IRC §731(a)(1), (c)(1). Here, the general partnership, if there is one, is distributing shares in a public corporation. Thus, the distribution of the shares would require our reader to recognize gain.

The gain is short-term capital gain, because our reader held his partnership interest for less than 1 year, and the partnership held the shares for less than 1 year. The gain is taxed at ordinary income rates–the same tax rate that would apply if he had PFIC gains. Again, the only advantage of avoiding PFIC classification would be to reduce the associated paperwork.

Last thoughts

Could our reader get out of having to recognize PFIC gains? It is possible. There are reasonable arguments, though not necessarily winning ones. The startup exception might apply, or the managers and the manager holding company entered into a general partnership that held the shares.

But in this particular situation, the advantage to taking risky positions appears to be very small–it saves a bit of paperwork to prepare Form 8621. Whether the manager holding company is a PFIC, a normal corporation, or the general partner of a partnership, it seems that our reader would have to pay tax at ordinary income rates.

PFIC and CFCs