PFIC bought and sold in the same year – QEF electionAugust 17, 2011 - Phil HodgenPFIC and CFCs
Continuing the saga of how a PFIC is taxed, we now deal with the QEF election. Recall that we are thinking of an extremely simple fact pattern:
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 ways PFICs are taxed
PFICs are taxed in one of three ways:
the excess distribution method, which I discussed here,
the mark-to-market method, which I discussed here, and
the QEF rules.
Let’s look at the QEF rules and see how our mythical taxpayer is taxed on his US$500 gain.
The Qualified Electing Fund Rules
Let’s assume that it is possible to make the qualified electing fund election. I’m not going to talk about how and when you can do this — that’s an exhausting digression all by itself. Just assume you can do it.
The basic idea for the qualified electing fund method of taxation is that the PFIC’s income is taxed approximately like a domestic mutual fund: you take your pro-rata share of each year’s income as either ordinary income or capital gain, depending on what the PFIC tells you. We don’t care about distributions right now, because we’re talking about the sale of the PFIC — dispositions.
Dispositions are easy. But interestingly the only place I could find a clear statement of how they are taxed is in the 1986 Tax Act’s Blue Book, which has an admirably clear statement of how it works:
Gain recognized on disposition of stock in a PFIC by a U.S. investor is not taxed under section 1291 if the PFIC is a qualified electing fund for each of the fund’s taxable years which begin after December 31, 1986 and which include any portion of the investor’s holding period. This provision allows any unrealized appreciation in the stock of a qualified electing fund to be taxable as capital gain income (if the stock is a capital asset) and without the imposition of an interest charge. [See the 1986 Tax Act Blue Book at page 1030. Warning: it is a big PDF file.]
How do we know this is true? By looking at the Internal Revenue Code, of course. It is The Gospel. Section 1291(d)(1) says:
This section [i.e., Section 1291, which is the excess distribution rule] shall not apply with respect to . . . any disposition of stock in a passive foreign investment company, if such company is a qualified electing fund with respect to the taxpayer for each of its taxable years–
(A) which begins after December 31, 1986, and for which such company is a passive foreign investment company, and
(B) which includes any portion of the taxpayer’s holding period.
Thus, making the QEF election takes you out of the excess distribution rules (which mandate that you treat the gain as ordinary income). Where does that leave you? Section 1291(d) doesn’t say. That means you look at the general rules of the Internal Revenue Code to figure out what to do with this gain. I won’t lead you down the law student path that starts at Section 61. Just trust me when I tell you that you quickly figure out that the PFIC shares are a capital asset in your hands, which means that you have capital gain.
Conclusion: QEF elections rock
In the first episode of this little trilogy, I showed how the default method of taxing PFICs (the excess distribution rules) made the gain on sale of the PFIC stock into ordinary income. In the second episode, we saw how the PFIC mark-to-market rules reached the same result–gain on sale of the PFIC shares would be treated as ordinary income.
Here, however, the gain is capital gain. It is a short-term capital gain, since we assume you bought and sold the PFIC stock within a single calendar year.
The QEF election is a better place to be for a taxpayer:
- If you have no capital losses, the gain is taxed at ordinary income tax rates, so you are no worse off than you would have been under the excess distribution rules or the mark-to-market rules.
- If you have capital losses, however, you can use those capital losses to offset the short term capital gain from the sale of the PFIC stock.
QEF elections, Form 8621, and Schedule D
Let’s bring it all home. How is this reported on Form 8621? The answer is that the only thing that would go on Form 8621 is the election itself. The election is box A. You are instructed to fill in Lines 1 through 2c. Those lines have to do with distributions only–not dispositions. The only other place to go is Schedule D. So that’s where you report the disposition of your PFIC shares.