What is the heir’s basis in a PFIC inherited from a NRA?

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What is the heir’s basis in a PFIC inherited from a NRA?

Last week, I answered a question about a US heir’s basis and holding period in a PFIC that he inherited from a US parent. Today I will answer the same question for a scenario that is the same except the deceased parent was a nonresident alien instead of a US person. This (or some variation on this) is a question I have been asked several times over the past few months by various people:

Our client (a US citizen) inherited a PFIC from a nonresident alien (NRA) parent, and sold it in the same year inherited. What is the US heir’s basis? For purpose of the excess distribution calculation, would the holding period carry over from the deceased NRA parent’s holding period or does it start in the year inherited?

If you recall from last week, the US decedent did not have to recognize gain on the PFIC at time of death, and the US heir inherited the decedent’s basis and holding period. In this week’s scenario, the decedent is a nonresident alien and does not include the PFIC in his gross estate for US tax purposes. Similar to last week, the decedent does not recognize gain on the PFIC at the time of death. However, the outcome for the basis and holding period in the hands of the heir will be different in this situation.

The NRA decedent’s estate does not recognize gain in the US

Regulation section 1.1291-9(j)(1) says:

A corporation will not be treated as a PFIC with respect to a shareholder for those days included in the shareholder’s holding period when the shareholder, or a person whose holding period is included in the shareholder’s holding period, was not a United States person within the meaning of section 7701(a)(30). Regs. §1.1291(j)(1).

The PFIC Regulations, by their own terms, tell us that the PFIC rules do not apply to the PFIC held by the NRA’s estate, because the NRA and his estate are not US persons. This result makes sense, because it is a foreign person holding a foreign asset, and US tax law cannot make a foreign person recognize gain on foreign assets. The result is that the NRA decedent and his estate do not recognize any gain.

The mutual fund is a PFIC with respect to the US heir

The PFIC (let’s say for the sake of argument it is a foreign mutual fund) is a PFIC for the US person who inherits it, even though it is not a PFIC for the decedent he inherited it from. Therefore the question becomes: With all the weird PFIC rules for nonrecognition transfers, and the associated basis and holding period rules, what should the basis and the holding period be in the hands of the US heir who inherits a PFIC from a foreign person?

The US heir gets basis equal to fair market value

IRC §1014(a) contains the normal rule for step-up in basis of inherited assets. Generally, the heir gets a step-up in basis to fair market value for any assets he inherits from a decedent. IRC §1291(e) contains a special provision for a reduction in basis equal to the §1014 basis minus the decedent’s adjusted basis just before death. In other words, the PFIC rules force an heir to take a carryover basis rather than the normal step-up basis. Luckily for the US heir in our scenario, the statutory reduction in basis does not apply “in the case of a decedent who was a nonresident alien at all times during the holding period of his stock”. IRC §1291(e)(2). The US heir gets the full step-up in basis in the PFIC to fair market value at the time of decedent’s death under the rules of IRC §1014(a).

The US heir uses the normal holding period rule

Generally, an heir’s holding period in inherited property is long term, according to IRC §1223(9), even if it is sold within the same year inherited.​ Prop. Regs. §1.1291-1(h) deals with the rules that apply to PFICs inherited from decedents:​

Except as otherwise provided in this paragraph (h), section 1.1291-6(b)(5), 1.1291-9(f), or 1.1291-10(f), a shareholder’s holding period of stock of a PFIC is determined under the general rules of the Code and regulations concerning the holding period of stock. Prop. Regs. §1.1291-1(h)(1).

Prop. Regs. §1.1291-1(h)(2) talks about holding periods of PFICs inherited from US decedents. There is no other mention in Prop. Regs. §1.1291-1(h) about holding period on assets acquired from decedents. Because holding period for a PFIC inherited from a nonresident alien is not otherwise provided for in that paragraph, then we use the general rules of the Code and Regulations. That means we use the normal holding period rule of IRC §1223(9).

The normal holding period rule is weird for PFICs

Under the normal holding period rule, when a person acquires property from a decedent and sells it within one year of the decedent’s death, and the person’s basis in that property is determined under IRC §1014, then the person gets a long term holding period in the property:

In the case of a person acquiring property from a decedent or to whom property passed from a decedent (within the meaning of section 1014(b)), if—​

(A)the basis of such property in the hands of such person is determined under section 1014, and (B)such property is sold or otherwise disposed of by such person within 1 year after the decedent’s death,​

then such person shall be considered to have held such property for more than 1 year. IRC §1223(9).

The fact pattern at hand is exactly that: A person acquires property (a PFIC) from a decedent and sells it within one year of the decedent’s death. The US heir’s basis is determined under IRC §1014. The property is sold within one year of the decedent’s death. Therefore the heir’s holding period is more than one year. In the normal world where a decedent inherits property that is a capital asset, that makes sense — the heir is able to benefit from long term capital gain tax rates. But in the world of IRC §1291 PFICs, that doesn’t make sense. If you have a PFIC that has a holding period that begins before the current year, and you sell that PFIC in the current year, you must allocate your gain to each day in your holding period and then calculate tax and interest on a portion of the allocated gain. IRC §1291(a). That means you need to know the exact date your holding period started to compute your PFIC tax and interest. “More than one year” does not give you an exact date.

Don’t worry, there’s a rule for that

IRC §1291(a)(3)(A) says that “the taxpayer’s holding period should be determined under section 1223”. Oh. Wait. IRC §1223 is the Code section that put us in this weird place to begin with, telling us to make a holding period greater than one year when in reality it is not (which would of course be a good thing in non-PFIC situations). If you are like me, at this point you are probably wondering: Can’t we just take the position that the holding period is the actual holding period, regardless of §1223(9)? Personally I think that is probably reasonable, considering that the PFIC rules are an exception to the way things normally work, and the whole point of the long term holding period in IRC §1223(9) is to give you a break on tax. But I’m not a lawyer, nor am I a lawmaker, and I think this is a real area of uncertainty.​

Summary and some potential solutions

When a US heir inherits a PFIC from a nonresident alien decedent, the normal holding period and basis rules apply — meaning the heir gets a step-up in basis and holding period is always long term.​ This creates some ambiguity when you attempt to apply the excess distribution rules for a sale of the inherited PFIC that takes place in the same year the decedent dies – what is the exact start date of the holding period? For US persons who are going to inherit PFICs from nonresident aliens, perhaps the lesson is to have your foreign relative sell the PFIC before they die, or not leave it to you at all. Chances are, though, you didn’t even know you were going to inherit it. Another option is for the heir to wait to sell the PFIC until more than a year after the decedent dies. In that situation, IRC §1223(9) doesn’t force you into a holding period that is not your actual holding period (because your holding period really truly is long term). Doing it this way eliminates ambiguity about holding period start date, but means there is with 100% certainty an excess distribution throwback period, meaning less than optimal tax results. Fortunately, you are only subject to 1 year of interest on the excess distribution. For some people, having certainty on how the IRS will treat the sale may be worth paying a little more in tax than living with uncertainty.

Thank you

Thank you, as always, for reading, hire a professional if you need help, and I’ll see you in a couple weeks.​ Debra