When a PFIC stops being a PFICAugust 13, 2015 - Debra RuddPFIC and CFCs
Greetings from Debra Rudd.
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When a PFIC stops being a PFIC
Today I am going to talk about the following scenario:
A US person named Sam invested in a foreign startup on June 30, 2010. Sam has at all times since June 30, 2010 owned 5% of the value and voting power in the startup. No other owners are US persons. The company owns nothing but $1M cash (contributed by Sam and the other owners), a $1M intellectual property asset (developed over time since the company’s inception), and a few laptops.
During 2010-2014, the company earns interest income on its bank account, but does not earn any other income.
In 2015, the company is finally ready to sell the service it has been developing and turns a profit for the first time.
Sam has never made any elections with respect to the startup.
I will discuss why the company is a PFIC for Sam, why it continues to be treated as a PFIC even after it stops qualifying as a PFIC under IRC §1297(a), and how he can terminate the PFIC treatment using a purging election when the company stops being a PFIC. I will specifically discuss how Sam makes the deemed sale election and what its tax effects are.
The startup is a PFIC for Sam
A foreign corporation that meets either the income test or the asset test under IRC §1297(a) is a PFIC.
The asset test asks whether 50% or more of the company’s assets are passive or are held for the production of passive income. Between the laptops and the $1M IP asset, the company has slightly more non-passive assets than its $1M passive cash assets. Less than 50% of its assets are passive. Let us assume this has been the case for all years since 2010. It is not a PFIC with respect to the asset test.
The income test asks whether 75% or more of the company’s income is passive, as “passive” is defined under IRC §954(c). From 2010-2014, the company’s only income is interest income. Passive income under IRC §954(c) includes interest income. Therefore 100% of the company’s income is passive. The company is a PFIC with respect to the income test.
Because the startup meets one of the two test under IRC §1297(a) during all years 2010-2014, it is a PFIC.
In 2015, the company stops meeting the definition of a PFIC. It continues to not meet the asset test, because it has more value in its IP and laptops than it has cash in the bank, so less than 50% of its assets are passive. It no longer meets the income test, because the vast majority of its income is from operations, and interest income is now a minority share of the company’s earnings. In 2015, the company meets neither the asset test or the income test.
Does Sam still have a PFIC in 2015, even after the startup no longer qualifies as a PFIC under IRC §1297(a)?
Once a PFIC, always a PFIC
The company continues to be a PFIC in 2015, even though it no longer satisfies the income test and no longer meets the definition of a PFIC.
Why is this the case? It comes from what is commonly referred to as the “once a PFIC, always a PFIC” rule of IRC §1298(b)(1), which states:
Stock held by a taxpayer shall be treated as stock in a passive foreign investment company if, at any time during the holding period of the taxpayer with respect to such stock, such corporation (or any predecessor) was a passive foreign investment company which was not a qualified electing fund. The preceding sentence shall not apply if the taxpayer elects to recognize gain (as of the last day of the last taxable year for which the company was a passive foreign investment company (determined without regard to the preceding sentence)) under rules similar to the rules of section 1291(d)(2).
In other words, if your stock in a foreign company meets the definition of a PFIC at any time during your holding period, it continues to be treated as a PFIC forever, even after it no longer meets the PFIC definition. Sam’s PFIC continues to be a PFIC for 2015 simply because it qualified as a PFIC in the past, even though it no longer qualifies as a PFIC.
The only way you can stop the application of the PFIC rules to the stock of a former PFIC is to make a purging election. There are two possible purging elections that a shareholder could make to remove the PFIC treatment: a deemed sale election or a deemed dividend election.
Sam is eligible to make a deemed sale election
According to Regs. §1.1298-3(b)(1), Sam may make a deemed sale election:
A shareholder of a foreign corporation that is a former PFIC with respect to such shareholder may make a deemed sale election under section 1298(b)(1) by applying the rules of this paragraph (b).
In other words, any shareholder of a corporation that was a PFIC and ceases to be PFIC can make the deemed sale election. Sam can make the deemed sale election.
Sam cannot make the deemed dividend election
Sam does not, however, have the option of making the deemed dividend election, according to Regs. §1.1298-3(c)(1):
A shareholder of a foreign corporation that is a former PFIC with respect to such shareholder may make the deemed dividend election under the rules of this paragraph (c) provided the foreign corporation was a controlled foreign corporation (as defined in section 957(a) (CFC)) during its last taxable year as a PFIC. A shareholder may make the deemed dividend election without regard to whether the shareholder is a United States shareholder within the meaning of section 951(b). A deemed dividend election may be made by a shareholder whose pro rata share of the post-1986 earnings and profits of the PFIC attributable to the PFIC stock held on the termination date is zero.
Sam cannot make the deemed dividend election because the company is not a controlled foreign corporation, or CFC. To be a CFC, more than 50% of the company’s stock, by value or voting power, must be owned by US shareholders. IRC §957(a). A “US shareholder” in this context is a US person who owns 10% or more of the voting power of the corporation. IRC §951(b).
In our example, there are no US shareholders as defined under IRC §951(b) because no US person has 10% or more of the voting power. The total ownership of the company by US persons is 5%. Therefore the company is not a CFC.
Because the company is not a CFC, Sam cannot make the deemed dividend election and must make the deemed sale election.
How the deemed sale election works
When Sam makes the deemed sale election, he is treated as having sold all his stock in the startup for its fair market value as of the last day of the last year that the company qualified as a PFIC (aka the “termination date”).
Any gains from the deemed sale are taxed as excess distributions received on the termination date, and any losses from the deemed sale are not recognized. After the deemed sale election, the shareholder’s stock is not taxed as PFIC stock any more, unless it meets the definition of a PFIC again at some future time. Regs. §§1.1298-3(b)(2) and (d).
A shareholder increases his basis in the stock by the gain recognized in the deemed sale. Regs. §1.1298-3(b)(5). A shareholder’s holding period in the stock is treated as beginning on the day following the termination date for the purposes of applying the PFIC rules only. Regs. §1.1298-3(b)(6).
The company ceased to meet the definition of a PFIC as of the 2015 calendar year, when for the first time it received less than 75% passive income. At that point, it no longer qualified as a PFIC under IRC §1297(a), because it met neither the income test nor the asset test. The termination date is the last day of the last year that the company qualified as a PFIC. Therefore the termination date is December 31, 2014. The deemed sale takes place as of that date.
Tax effects of deemed sale election
Let us assume that Sam’s basis in the company is 5% of $1M, or $50,000. Let us further assume that the fair market value of the company upon termination date is $2M, and Sam’s share of that is $100,000.
Sam will be recognizing a gain of $50,000, then applying the excess distribution rules of IRC §1291 to that gain. Without going into detail on how to do the excess distribution calculations, Sam will have about $20,000 to pay in tax and interest to terminate the PFIC rules for his startup stock.
That is a very high tax to pay on a $50,000 growth in investment — 40%, to be precise. It is especially high when you consider that Sam has not, at this point, received a single dollar from the company — it has paid him nothing and made no distributions.
Those of you who tuned in to the recent series of newsletters I wrote on CFC-PFIC interaction and saw the comparison between the deemed sale and deemed dividend elections in that scenario (where the company’s value was high but its E&P was effectively $0) are probably thinking “wow, Sam would be so much better off if he could take advantage of the deemed dividend election”.
Indeed, you are correct. The IRS seems to give a somewhat more favorable treatment of PFICs that are also CFCs — and I would guess this is the case because of the extensive reporting required and Subpart F provisions for CFCs.
How to fill out Form 8621
To make the purging election, Sam selects box F in Part II of the 2014 Form 8621 for Election to Recognize Gain on Deemed Sale of PFIC.
Sam goes to Part V of Form 8621 and enters $50,000 on Line 15f. He then fills in the rest of Part V to show his excess distribution calculations, and then flows the income, tax, and interest to the appropriate lines of Form 1040.
Sam no longer has a PFIC
Now that Sam has made the deemed sale election for the 2014 tax year, his stock in the startup will not be treated as a PFIC unless it once again meets the PFIC definition under IRC §1297(a) at some point in the future. This non-PFIC status comes at a relatively high price — $20,000 of tax and interest, or in percentage terms a 40% tax on the unrealized gain. It is only a small consolation that his basis is increased by the $50,000 gain recognized.
If the PFIC had also been a CFC, Sam would have been able to take advantage of the deemed dividend election and could have paid $0 tax for the privilege of not having a PFIC.
As always, thank you for reading all the way to the bottom of the email, and please feel free to hit “reply” and type me a message if you have any PFIC questions. I’ll see you again in two weeks.
And if you have a real tax problem and need real advice, hire someone to help you. This newsletter is marketing material and as such is vague, probably skips some critical details, and may not apply to your specific situation.