Hello from Debra Rudd.
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Today I will answer the following question:
A US citizen inherited a PFIC from a US citizen parent, and sold it in the same year inherited. The US parent never made any elections for the PFIC. What is the US heir’s basis? For purpose of the excess distribution calculation, would the holding period carry over from the deceased parent’s holding period or does it start in year inherited?
This is a question about basis and holding period for someone who inherits a PFIC, but to answer it properly, we have to understand the PFIC gain recognition principles, and we have to know whether gain was recognized by the decedent’s estate upon transfer.
The PFIC rules contain a special provision that permits the Treasury to adopt regulations that require recognition of gain even when there is normally no recognition of gain:
To the extent provided in regulations, in the case of any transfer of stock in a passive foreign investment company where (but for this subsection) there is not full recognition of gain, the excess (if any) of—
(1) the fair market value of such stock, over
(2) its adjusted basis,
shall be treated as gain from the sale or exchange of such stock and shall be recognized notwithstanding any provision of law. Proper adjustment shall be made to the basis of any such stock for gain recognized under the preceding sentence. IRC §1291(f).
Prop. Regs. §1.1291-6(a)(2) tells us that these nonrecognition transfers include transfers by death:
A nonrecognition transfer includes, but is not limited to, a gift, transfer by reason of death, a distribution to a beneficiary ty a trust or estate…
So the estate is required to recognize gain equal to fair market value of the PFIC at time of death minus adjusted basis in the PFIC.
For a PFIC that is transferred to a US person as an inheritance, and cannot be transferred to a foreign person, the decedent’s estate does not recognize gain, according to Prop. Regs. §1.1291-6(c)(2)(iii)(A):
Except as provided in paragraph (c)(2)(iii)(B) of this section, gain is not recognized to a shareholder upon a disposition of stock of a section 1291 fund that results from a nonrecognition transfer to the shareholder’s domestic estate or directly to another U.S. person upon the death of the shareholder.
Paragraph (c)(2)(iii)(B) says:
Gain is recognized to a shareholder on the transfer of stock of a section 1291 fund to the shareholder’s domestic estate if, pursuant to the terms of the will, the section 1291 fund stock may be transferred to either a foreign beneficiary or a trust established in the will.
Let us assume for the scenario at hand that the PFIC in our US decedent’s estate could not have been transferred to a foreign person or to a trust, and that the US citizen heir is the only heir to the estate.
This exception under Prop. Regs. §1.1291-6(c)(2)(iii)(A) to the non-recognition override rule of IRC §1291(f) will apply to our scenario, and no gain will be recognized by the decedent’s estate.
Prop. Regs. §1.1291-6(b)(4)(iii) says:
Unless all of the gain is recognized to a shareholder (the decedent) pursuant to paragraph (c)(2)(iii)(B) of this section, the basis of stock received on the death of the decedent by the decedent’s estate (other than a foreign estate within the meaning of section 7701(a)(31)), or directly by another U.S. person, is the lower of the fair market value or adjusted basis of the transferred stock in the hands of the shareholder immediately before death. If gain is recognized by the decedent, the decedent’s adjusted basis of the stock of the section 1291 fund is increased by the gain recognized with respect thereto.
In our scenario, no gain was recognized by the decedent because an exception applied. Therefore, the basis in the hands of the heir will be the lower of the fair market value or adjusted basis of the transferred stock in the hands of the decedent immediately before death.
It is probably safe to assume that fair market value at time of death exceeded adjusted basis, if the heir is able to sell the PFIC at a gain in the same tax year as the inheritance occurred. Therefore, the heir in our scenario will take a basis equal to the decedent’s adjusted basis just before he died.
The holding period rule is found in Prop. Regs. §1.1291-1(h):
For purposes of section 1291 and these regulations, a shareholder’s holding period of a share of stock of a PFIC includes the period the share was held by another U.S. person if the shareholder acquired the share by reason of the death of that other U.S. person (the decedent), the PFIC was a section 1291 fund with respect to the decedent, and the decedent did not recognize gain pursuant to section 1.1291-6(c)(2)(iii) (or would not have recognized gain had there been any) on the transfer to the shareholder.
For the heir in our example, all of the criteria are met:
Therefore, the US heir’s holding period includes the period the PFIC was held by the US decedent.
Both the basis and the holding period carry over from the decedent to the heir.
The US heir in our scenario will have a gain much larger than he would if he were able to take basis equal to fair market value at time of decedent’s death.
He will also have to apply his gain over the entire holding period (going back to when his US parent acquired the PFIC) under the excess distribution rules, meaning a large tax and interest charge due to the large throwback period.
If the US heir had been able to start his holding period in the year of inheritance, the entire gain would be ordinary income, and there would be no throwback period, and no associated maximum tax rates and daily compounded interest charges.
However, the total gain recognition is ultimately the same, whether it is recognized in part by the decedent’s estate on date of death and in part by the heir on date of sale, or in total by the heir on the date of sale.
Let us imagine for a moment that the heir did not get carryover basis and holding period from the decedent. In that case, gain equal to fair market value on date of death minus decedent’s adjusted basis would be recognized by the estate, and gain equal to fair market value on date of sale minus fair market value on date of decedent’s death would be recognized by the heir. If the estate recognizes gain, the terms of the will may permit the tax to be allocated to each beneficiary, but the overall tax until sale remains the same.
You, my very astute reader, probably noticed that the override to the nonrecognition principle is set forth in the Code, whereas the exception to that override is found in the Proposed Regulations. In fact, every citation in this newsletter apart from the nonrecognition override principle of IRC §1291(f) comes from Proposed Regulations.
As those of us who are students of tax law are well aware, the Code is law, and Proposed Regulations are not. I wrote this newsletter from the perspective of assuming that the Proposed Regulations do, in fact, guide our every move in the field of tax, but the reality is that sometimes that is not the case.
Back on May 8, 2015, Phil wrote an interesting blog post that comments on this very matter: Do we follow the Proposed Regulations (because that is what auditors are instructed to use) or do we disregard them completely (because they won’t hold up in Tax Court)? On this particular matter I refrain from comment, except to point out that the Proposed Regulations provide the only explicit guidance that currently exists on the subject.
That’s it for this week. Thank you, as always, for reading. Remember that this newsletter is fun for me to write but is by no means tax advice to you. If you’d like to send me a question or comment, please hit “reply” and start typing, then hit “send”.