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March 23, 2017 - Haoshen Zhong

Your Stock Options in a PFIC

Getting a stock option from a PFIC

Here is a question from an email:

I am employee of a PFIC. My employer issued some stock options to me as part of my compensation. Do I have a PFIC problem?

This post describes why you cannot avoid passive foreign investment company (PFIC) taxes by holding onto an option or selling the option directly. But you may want to hold onto the option to reduce annual reporting requirements.

The option is an issue because of attribution rules

A passive foreign investment company (PFIC) is a special subcategory of foreign corporations. US shareholders of a PFIC are subject to punitive tax rules, so US persons want to avoid owning shares of a PFIC.

For this post, I assume you already know that you are dealing with a PFIC, so we only need to address the stock options.

The Internal Revenue Code contains attribution rules for PFIC share ownership to prevent US persons from using wrappers to avoid the PFIC rules. IRC §1298(a). One rule states:

To the extent provided in regulations, if any person has an option to acquire stock, such stock shall be considered as owned by such person… IRC §1298(a)(4).

Depending on what regulations the IRS has issued, your stock options in a PFIC can create PFIC issues for you.

Selling your option is treated as selling a PFIC

The IRS has not issued any final or temporary regulations about stock options, but it did propose 2 rules for options. The first rule says:

If a US person has an option to acquire stock of a PFIC […], such option is considered to be stock of a section 1291 fund for purposes of applying section 1291 and these regulations to a disposition of the option. For purposes of this paragraph (d), the exercise of an option is not a disposition to which section 1291 applies. Prop. Treas. Reg. §1.1291-1(d).

Section 1291 contains the default rules for taxing PFIC income. If you do not make a special election for your PFIC shares, the default rules under section 1291 apply. A section 1291 fund refers to a PFIC share that is taxed under the default rules.

What this proposed rule says is that if you transfer your options, the transfer of the options is treated as a transfer of shares in a PFIC. This rule prevents you from avoiding PFIC taxation by transferring the options directly rather than first converting the options to PFIC shares.

Your option holding period increases your PFIC holding period

The second rule under the proposed regulations says:

The holding period of a share of stock of a PFIC acquired upon the exercise of an option includes the period the option was held. Prop. Treas. Reg. §§.1291-1(h)(3).

This rule is best illustrated with an example. Suppose your employer grants you an option to acquire 100 shares on 2005-01-01. You exercise your options and acquire 100 shares on 2017-01-01, then sell the shares immediately.

Suppose your employer is not a PFIC. Under normal rules for holding period of property, your holding period for the shares begins on 2017-01-01, the day you exercised your options. IRC §1223(5). Thus, you have a holding period of 0 days.

Under the proposed rule, if your employer is a PFIC, then your holding period begins on 2005-01-01, the day the options were issued. Thus, you have a holding period of 12 years.

The holding period rule increases the tax you pay

Why does the IRS want your option holding period to increase your PFIC holding period? It has to do with way taxes are imposed on PFICs under the default rules. Here is an abridged version of the rules that apply to the sale of a PFIC share. IRC §1291.

  1. When you sell a PFIC share, all your gain is “excess distribution”.
  2. Your excess distribution is allocated evenly, by day, over your entire holding period.
  3. Excess distribution allocated to the current year is ordinary income.
  4. Excess distribution allocated to prior years is taxed at maximum tax rates for the prior years. This tax is the prior year excess distribution tax.
  5. Interest is imposed on the prior year excess distribution tax, as if you owed tax from the prior years.

Returning to our example: Suppose your employer grants you an option to acquire 100 shares on 2005-01-01. You exercise your options and acquire 100 shares on 2017-01-01, then sell the shares immediately.

If your holding period begins on 2017-01-01, then your entire gain is allocated to the current year. Thus, the entire gain is taxed at ordinary income rates for the current year. You avoid interest charges.

If your holding period begins on 2005-01-01, then almost all gain is allocated to the 12 prior years. Thus, you pay a significant interest charge for gains allocated to prior years.

The proposed regulation forces you to include your option holding period in the PFIC share holding period. Thus, regardless of when you actually exercise your options, the holding period begins on the day you receive the options. Thus, you cannot avoid the PFIC interest charge by holding onto options.

You may want to hold onto the options to avoid annual reporting requirements

If you hold more than $25,000 worth of shares in PFICs, you must file Form 8621 annually to report all your PFIC shares. Reg. §1.1298-1T.

The option attribution rules require you to treat stock options as shares in a PFIC under 2 circumstances:

  1. You must treat stock options in a PFIC as share in a PFIC when you sell the option.
  2. You must include your holding period for the option in your holding period of shares acquired from exercising the option.

There is nothing about treating stock options in a PFIC as shares in a PFIC for the purpose of annual reporting requirements. Thus, if you hold onto the options, you can reduce your annual compliance requirements slightly.

Summary

If you sell stock options in a PFIC, the sale is treated in the same way as if you actually sold shares in a PFIC. If you exercise your options, the PFIC shares you receive have a holding period that start on the day you received options. This makes the tax results the same whether you sell the option or the PFIC shares. It makes the tax results the same regardless of when you exercise your options. Holding onto the option does not affect your tax liability.

But you may want to hold onto the options to avoid annual reporting requirements.

PFIC and CFCs