This is a question we got in an email:
My client bought shares in a foreign mutual fund a few years ago. I see from the client’s statements that the average distribution for the last few years has been about the same, but I do not have statements for the entire first year. Can I annualize the first year distribution?
This post will discuss how to annualize the first year distribution to reduce the tax on distributions from a passive foreign investment company.
A passive foreign investment company (PFIC) is a foreign corporation that meets either one of the following two tests (IRC §1297(a)):
Generally, foreign mutual funds are PFICs, even if they are not organized as corporations in the foreign jurisdiction, because they hold passive assets.
Income from PFICs (whether gain or distribution) is subject to special punitive rules to discourage US persons from making passive investments abroad. If a US person invested in a PFIC it is useful to consider if there is any rule that can reduce the tax on the PFIC income.
Annualizing the first year distribution is a rule that can reduce the tax on PFIC distributions, but to understand how this works, we must first understand how PFIC distributions are taxed. Generally, PFICs can be taxed in one of three ways:
The annualization rule applies only to the default regime, so we will ignore the MTM and QEF regimes for this post. IRC §1291(b)(3)(C).
In simplistic terms, this is how the US tax works when you receive a distribution (dividend, return of investment, etc) from a PFIC under the default regime. IRC §1291.
First, you divide the distribution into excess distribution and non-excess distribution. The non-excess distribution is treated like a distribution from a normal corporation. IRC §301(c). The only difference is that a PFIC cannot distribute a qualified dividend. IRC §1(h)(11)(C)(iii).
Second, you divide the excess distribution into three intervals pro-rata by days in the holding period: the pre-PFIC period, the prior year PFIC period, and the current year. The pre-PFIC excess distribution and current year excess distribution are included in gross income as ordinary income. The prior year PFIC excess distribution is not included in gross income. The prior year PFIC excess distribution is taxed at maximum rates and subject to an interest charge.
The prior year PFIC excess distribution is known as the “excess distribution not included in income”, and it is an important concept in understanding how annualizing the first year distribution can reduce PFIC tax.
Non-excess distribution is taxed more favorably than excess distribution, so you want to use available rules that allocates more of a distribution to non-excess distribution.
This is how you find the non-excess distribution:
If the quotient is less than or equal to the distribution received this year, then the quotient is the non-excess distribution this year. If the quotient is greater than the distribution received this year, then the entire distribution received this year is non-excess distribution.
From this equation, you can see that you would typically expect to have a low excess distribution when the distributions from the past 3 years are high. Further, your second year excess distribution would be made lower if your first year distribution were higher.
There is a rule that says even if you do not hold the PFIC shares for the entire year in the first year of your holding period, you may be able to include all distributions the PFIC made in the first year for purposes of calculating non-excess distributions in subsequent years. Prop. Treas. Reg. §1.1291-2(d)(1).
Note that this rule is only for the purpose of calculating non-excess distributions in subsequent years. It does not change the tax liability for the first year.
Let us look at a simplistic example to illustrate the concept: You buy a share of a PFIC on July 1 of year 1. The PFIC made a $1,200 distribution on January 1 of year 1. In years 2-5, the PFIC made a $1,200 distribution on December 31 of each year.
This is how non-excess distribution is calculated if you annualize the first year of distributions:
This is how non-excess distribution is calculated if you do not annualize the first year of distributions:
These are the results, side by side:
|Year||Annualize||Do not Annualize|
As you can see, using our assumed numbers, you saved $2,644.54 of excess distribution in the first five years by annualizing the first year of distributions. What is particularly interesting is that even though the first year distribution is not directly used in calculating the excess distribution in year five, annualizing the first year distribution reduced the excess distribution in year five, because annualizing the first year distribution reduced the “excess distribution not included in income” in years two through four.
Depending on the distribution pattern, annualizing the first year distribution can have a ripple effect beyond just the first four years.
Now we know annualizing the first year distribution can (though may not necessarily) decrease tax liability. The question is what requirements there are to annualize the first year distribution.
The tricky part is that you must know the actual payments made during the first year but before your holding period began.
Let us apply this requirement to our original question:
My client bought shares in a foreign mutual fund a few years ago. I see from the client’s statements that the average distribution for the last few years have been about the same, but I do not have statements for the entire first year. Can I annualize the first year distribution?
You cannot annualize the first year distribution based on the information you have now, because you do not know the actual distributions the mutual fund made in the first year of your client’s holding period (but before the holding period began). You will need to go and find the fund statements for the first year of your client’s holding period.
It is ok if you cannot find all statements. You can annualize distributions based on statements you can find. For example, suppose your client bought the fund shares in the third quarter, and you can find distribution statements for the second, third, and fourth quarters only. You can annualize the second quarter, despite not having information about the first quarter.
Annualizing the first year distributions can save taxes by reducing excess distribution for subsequent years. But finding statements so you can annualize first year distributions may be difficult. This is a matter of cost: Is it better to save some taxes, or is it better to save tax preparation fees?