Good morning from Haoshen Zhong.

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Keeping your startup from being a PFIC

Two weeks ago we talked about what happens when a PFIC stops being a PFIC. We briefly talked about why a tech startup is a PFIC for a US shareholder. This week, let’s go back to the beginning and talk about what makes a PFIC a PFIC, and how a US person can avoid having her stock in a foreign startup be subject to PFIC treatment.

Assumptions

Let’s assume the following:

Aerith is a US citizen. She has four friends from Germany, all of whom are nonresident aliens. They have a great idea for a new software. They want to create a Gesellschaft mit beschränker Haftung (GmbH) to develop the software.

They estimate that it will take two years for the software to be ready for market. Each person is committed to contributing USD 100,000 of cash as the startup capital while they develop the software.

The income test and the asset test for PFIC status

A passive foreign investment company (PFIC) is defined in IRC §1297(a):

except as otherwise provided in this subpart, the term “passive foreign investment company” means any foreign corporation if—

(1) 75 percent or more of the gross income of such corporation for the taxable year is passive income, or

(2) the average percent of assets (as determined in accordance with subsection(e)) held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50 percent.

These are called the income test (IRC §1297(a)(1)) and the asset test (IRC §1297(a)(2)). If a foreign corporation meets either test, then it will be a PFIC.

The GmbH is foreign because it is incorporated in Germany and under German laws. Reg. §301.7701-5(a). It is a corporation because it provides limited liability for all members. Reg. §301.7701-2(b)(2), -3(b)(2)(i)(B). So the GmbH is potentially subject to PFIC rules.

Suppose Aerith and her friends simply put USD 500,000 of cash into an interest bearing account and start to develop the software, spending cash as they go. This will be bad (and cause the GmbH to be a PFIC) for two reasons:

1. Interest is passive income, even if it is earned on working capital. IRC §954(c)(1)(A). The small amount of interest that the account earns is 100% of the GmbH’s income, so the GmbH will be a PFIC under the income test.
2. Cash is a passive asset, even if it is working capital. Notice 88-22; 1988-1 C.B. 489. The GmbH will have some business assets, but probably not enough to spend more than half of the USD 500,000 cash, so the GmbH will be a PFIC under the asset test.

Because the GmbH is a foreign corporation and will meet one or both of these tests, it will be a PFIC.

The startup exception doesn’t work very well

IRC §1298(b)(2) has a narrow exception for startups, exempting them for one year from PFIC status:

A corporation shall not be treated as a passive foreign investment company for the first taxable year such corporation has gross income (hereinafter in this paragraph referred to as the “start-up year”) if—

(A) no predecessor of such corporation was a passive foreign investment company,

(B) it is established to the satisfaction of the Secretary that such corporation will not be a passive foreign investment company for either of the 1st 2 taxable years following the start-up year, and

(C) such corporation is not a passive foreign investment company for either of the 1st 2 taxable years following the start-up year.

This exception does not work well for Aerith, because it only exempts GmbH from PFIC status for the first taxable year in which the GmbH has gross income. That first year will be the year that it earns interest income on the capital contributed to the GmbH. It is estimated that it will take two years for the software to become profitable. The startup exception is probably too short. The GmbH will meet the income test and the asset test before it starts to be an active business.

Step 1: Keep the cash in a non-interest bearing account

The GmbH met the income test because Aerith and friends decided to keep the cash in the GmbH’s interest-bearing account. If the GmbH keeps the cash in a non-interest bearing account, then the GmbH will have no income at all. This is Step 1 of the strategy to prevent PFIC status.

The IRS addressed this type of situation in PLR 9447016. In that private letter ruling, the foreign corporation was a manufacturing company whose gross receipts plus income from all other sources for the year was less than its cost of goods sold. For a manufacturer, cost of goods sold is used in calculating gross income rather than deducted as an expense. Reg. §1.61-3. The result was that the company had no gross income for the year. The IRS held that the company was not a PFIC under the income test for that year, because:

The gross income test does not apply where a foreign corporation has no gross income determined pursuant to the principles of section 61 of the Code and subpart F. PLR 9447016.

This is a private letter ruling, so it does not bind the IRS in any subsequent case, but it gives insight into how the IRS treats the income test. The result is fairly logical: If the company has no income, then it shouldn’t meet a test that is designed to capture companies with passive income.

As tempting as it might be to keep cash working by using an interest-bearing account, investing in cash equivalents, or investing in other assets, Aerith should convince her friends to forgo the small advantages to help her with her US tax situation. The GmbH should keep its working capital in a non-interest bearing account.

Step 2: Acquire business assets

Keeping cash in a non-interest bearing account will solve the income test problem, but the asset test problem remains. A corporation only needs to meet one of the two tests to be classified as a PFIC. Cash is a passive asset, regardless of whether it is in an account that generates interest. The GmbH needs to take additional steps to avoid being classified as a PFIC because of the asset test.

Depreciable property used in a trade or business is a nonpassive asset. Notice 88-22. Leased property under a lease term of at least 12 month is treated as actually owned by the corporation, valued as the unamortized portion of the present value of the payments under the lease using applicable federal rates. IRC §1298(d).

A common practice for small software startups is for each of the founder to use her own computer as the client computer and only acquire servers (if any) for the company. Aerith should convince her friends to contribute the computers to the GmbH or have the GmbH acquire computers for them, so the company has some nonpassive assets on its books. By acquiring some business assets, the startup has taken some measures to eliminate the asset test problem.

Step 3: Contribute cash on an as-needed basis

Five laptops as corporate assets is not very much compared to all that cash. Cash is a passive asset, even if it is working capital for the trade or business. Notice 88-22. The same is true of other working capital that is readily convertible into cash. Notice 88-22.

The GmbH can avoid PFIC status under the asset test if its founders contribute cash only as the need arises. If the GmbH has little to no cash and substantial amounts in computing equipment, then it’s unlikely to be treated as a PFIC under the asset test.

If the founders have a binding agreement that the GmbH can enforce for additional cash contributions, then it is possible that the agreement will be treated (by the IRS, for purposes of the asset test) as cash. To prevent this result, the founders should have an agreement between themselves to commit capital. The GmbH should not be allowed to enforce the agreement.

When the GmbH starts operating

Taking steps 1 to 3 can solve the PFIC problem while the GmbH is developing its software. At some point, the startup will be ready to market its software. The software would have some value at that point. Keeping the GmbH from being classified as a PFIC is more straightforward at that point.

IRC §954(c)(1) generally classifies royalties and gains from sale of assets that generate royalties as passive income. IRC §954(c)(1). But this doesn’t apply if the royalties are generated in the active conduct of a trade or business and not from a related person. IRC §954(c)(2)(A).

Fortunately, royalties from the licensing of software that a foreign corporation developed itself (or modified extensively after acquiring from another party) will be nonpassive income. Reg. §1.954-2(d)(1)(i). Because the software produces nonpassive income, the software itself is classified as a nonpassive asset. Notice 88-22.

For this startup, once it has developed its own software, the royalties it receives from the software licenses will be nonpassive income. At that point, it’s unlikely that the GmbH will meet the income test for a PFIC.

The GmbH might meet the asset test if the GmbH accumulates too much cash. Fortunately, the software is probably the GmbH’s most valuable asset, and the software is nonpassive asset. If the foreign corporation is not a controlled foreign corporation (CFC), then the asset test uses the fair market value of property. IRC §1297(e). The GmbH is not a CFC, because the only US person owns only 20% of the GmbH. IRC §§951(b), 957(a). The GmbH gets to count the fair market value of the software as a nonpassive asset. Keeping track of the software’s fair market value by getting timely appraisals would generally document the GmbH as a non-PFIC.

Summary

A foreign corporation will be classified as a PFIC if it meets either one (or both) of the two tests under IRC §1297: the income test or the asset test. A foreign corporation must make sure it meets neither of the tests.

A startup can eliminate the income test problem by keeping its cash in a non-interest bearing account. Keep the cash as cash and do not purchase investments. This becomes less necessary as the company starts to earn royalty from the software it develops.

To eliminate the asset test problem, there are a few measures a startup can take:

• acquire business assets;
• keep the cash balance low by making contributions on an as-needed basis only; and
• keep careful track of the value of the corporate IP.

It is likely that a company will take a combination of these three measures to make sure it does not meet the asset test.

Thank you

Thank you for reading this newsletter. Please feel free to hit “reply” and send me a message if you have any PFIC questions. See you again in 2 weeks.

This newsletter isn’t tax advice. You should hire someone to help you if you need tax advice. This newsletter is marketing material and may have omitted important details that apply to your specific circumstances.

Your next installment of the PFICs Only newsletter will come in two weeks. See you then.

Haoshen

Greetings from Debra Rudd.

You are receiving this message because you are signed up for our PFICs Only newsletter, delivered to you via e-mail every other Thursday morning at 6am Pacific Time. To stop receiving these emails, scroll down to the bottom of this message and click “unsubscribe”. If you would like to see what other mailing lists we offer, go to hodgen.com/lists. If you would like to talk to me, hit “reply” to this message and start typing.

Inbound transition rule for MTM election

I received the following question from reader K:

I have client who filed as a nonresident in 2013 and previous years. In 2014 he passed the substantial presence test and is filing a resident return. He has an Australian mutual fund that he has had for years. He only has his 2013 and 2014 year end statements. Can we make a mark-to-market election for him using his 2013 year end value as his adjusted basis? Or do we need to determine what his actual cost basis is?

The short answers to those questions are: You can make the MTM election using the 2013 year end value as the adjusted basis, but you still need to know the actual cost basis for when the fund is sold.

I will assume that the fund is a marketable security under IRC §1296(e), and that K’s client is therefore eligible to make the MTM election. I will talk about how to compute the MTM gains when the first year of US tax residency is 2014, and how to compute your gains when you sell the mutual fund in 2015.

MTM election basics

The MTM election rules are found under IRC §1296. When you make the MTM election, you compute the annual increase or decrease in market value of a PFIC and report it as an ordinary gain or loss on your tax return. The ordinary losses, however, are limited to the amount of ordinary gains previously recognized (and the running total of how much ordinary loss you are able to take is called “unreversed inclusions”).

Each year you are recognizing gain equal to the increase in market value. Your basis in the fund increases accordingly. In the case of K’s client, the fund was owned for years before the client became a US person for tax purposes. Therefore, it is a reasonable question to ask for an inbound immigrant: Do I calculate my first year of MTM gains based on the market value of the end of the previous year, or based on my actual purchase price from years ago when I was not a US person?

Luckily, Congress has addressed this directly in the Code.

Inbound transition rule

IRC §1296(l) states:

If any individual becomes a United States person in a taxable year beginning after December 31, 1997, solely for purposes of this section, the adjusted basis (before adjustments under subsection (b)) of any marketable stock in a passive foreign investment company owned by such individual on the first day of such taxable year shall be treated as being the greater of its fair market value on such first day or its adjusted basis on such first day.

In other words, your PFIC gets a step up in basis to fair market value as of the first day of your first taxable year as a US person for the purposes of MTM calculations, if the fair market value as of that day happens to be greater than your actual basis in the PFIC. I assume that is the case for K’s client: that the market value at the end of 2013 is greater than his actual basis in the fund.

Note that the basis step-up applies only for the purposes of MTM calculations. That means that the basis step-up does not apply for other purposes.

Basis step up for MTM calculations only

The Regulations demonstrate, by example only, how the calculations work for non-MTM purposes. Because there is no additional explanation, I will show the entire example from Regs. §1.1296-1(d)(5) here:

A, a nonresident alien individual, purchases marketable stock in FX, a PFIC, for $50 in 1995. On January 1, 2005, A becomes a United States person and makes a timely section 1296 election with respect to the stock in accordance with paragraph (h) of this section. The fair market value of the FX stock on January 1, 2005, is $100. The fair market value of the FX stock on December 31, 2005, is $110. Under paragraph (d)(5)(i) of this section, A computes the amount of mark to market gain or loss for the FX stock in 2005 by reference to an adjusted basis of $100, and therefore A includes $10 in gross income as mark to market gain under paragraph (c)(1) of this section. Additionally, under paragraph (d)(1) of this section, A’s adjusted basis in the FX stock for purposes of this section is increased to $110 (and to $60 for all other tax purposes). A sells the FX stock in 2006 for $120. For purposes of applying section 1001, A must use its original basis of $50, with any adjustments under paragraph (d)(1) of this section, $10 in this case, and therefore A recognizes $60 of gain. Under paragraph (c)(2) of this section (which is applied using an adjusted basis of $110), $10 of such gain is treated as ordinary income. The remaining $50 of gain from the sale of the FX stock is long term capital gain because A held such stock for more than one year.

As you can see, K’s client does get the basis step-up in his inbound transition year for the MTM election, but he will also need to know his original basis in the fund because he will need to compute gain upon sale under IRC §1001 for the portion of the gain not included in income under the MTM rules. That portion of the gain will be a capital gain.

Example

Let’s use the following numbers to do some calculations:

Assume that K’s client (let’s call him Tom) purchased the fund for $100 in 2006. At the end of 2013, the value of the fund is $150. At the end of 2014, the value of the fund is $160. In June of 2015, Tom sells the fund for $180.

2014 calculations (inbound immigration year)

Because of the basis step-up rule, Tom’s basis in the fund for MTM purposes is $150. He has a $10 MTM gain for 2014 because the market value of the fund at the end of 2014 is $160.

On his 2014 tax return, he will report a MTM gain of $10 on Form 8621 and include $10 of ordinary income on Line 21 of Form 1040.

His new adjusted basis in the fund for MTM purposes is $160. His new adjusted basis for all other purposes is $110 ($100 purchase price + $10 MTM gains).

2015 calculations (year of sale)

On his 2015 return, Tom will report the sale of his PFIC. Because the price of the fund increased in 2015, Tom will have to report both a MTM gain in 2015 and a non-MTM gain for the appreciation in value before he met the substantial presence test.

His MTM gain is the difference between the proceeds ($180) and his adjusted basis for MTM purposes ($160), or $20. He will report the sale on Form 8621, showing a $20 gain, and will include $20 of ordinary income on Line 21 of Form 1040.​

For his non-MTM gain: His actual basis in the fund when he became a US person was $100, his original purchase price from 2006. That basis for purposes other than MTM calculations increased to $110 when he reported $10 of MTM gain on his 2014 tax return.

He had $70 of gain when he sold ($180 proceeds minus $110 adjusted basis), $20 of which was ordinary MTM gains reported on Form 8621 and Line 21 of Form 1040. The remaining $50 will be a long term capital gain reported on Schedule D.

In effect, the amount of capital gain recognized upon sale is equal to the amount of basis step-up taken under IRC §1296(l) in the first year of US person status.

Summary​

For the purposes of MTM calculations only, inbound immigrants get to use the greater of their actual adjusted basis or fair market value on the first day of the first year of US person status under IRC §1296(l) when they make the MTM election in the first year of their US tax residency.

When they dispose of the PFIC, however, the portion of the appreciation not recognized under the MTM rules, either at the time of basis step-up or subsequently in the holding period, is a capital gain.

Thank you

Thank you for reading, please consult a professional if you need tax advice, and I’ll see you in two weeks.

Hello from Debra Rudd.

You are receiving this email because you are signed up for our “PFICs Only” newsletter, delivered directly to your electronic mailbox every other Thursday at 6:00 am Pacific time. To stop receiving this message, scroll down to the bottom and click “unsubscribe”. If you are interested in receiving more of these types of communications, check out our other mailing lists at hodgen.com/lists.

What is my basis in an inherited PFIC?

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.

Gain recognition for parent’s estate

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.

But there is (of course) an exception

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.

What is the heir’s basis?​

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.​

And what is the heir’s holding period?

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:

• The shareholder acquired the share by reason of the decedent’s death,
• The PFIC was a section 1291 fund with respect to the decedent because no elections were ever made for the PFIC, and
• The decedent did not recognize gain on the transfer to the shareholder.​

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.

What that means for the heir who sells the PFIC​

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.

A note about Proposed Regulations

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.

Thank you​

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”.

Hello from Debra Rudd.

You are receiving this email because you are signed up for our “PFICs Only” newsletter, delivered directly to your electronic mailbox every other Thursday at 6:00 am Pacific time. To stop receiving this message, scroll down to the bottom and click “unsubscribe”. If you are interested in receiving more of these types of communications, check out our other mailing lists at hodgen.com/lists.

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

Hello again from Phil Hodgen, and Happy 2016.

Work here

We are hiring.

You can see the job listings at hodgen.com/jobs. One admin/office manager, one accountant. That’s what’s on the plate at the moment.

But there will be more job listings to come in the next few months.

International Tax Lunch – Today

You are getting this at 6:00 a.m. Pacific time. At noon (Pacific time) today, our International Tax Lunch series for 2016 will kick off. I will be talking about the foreign earned income exclusion and Form 2555. Quick. Go to hodgen.com/lists and sign up so you can get the last-minute email with the conference call dial-in information.

Or just hit “Reply” and email me. We will make sure you get the announcement email so you can call in.

Also. If you want to come to our new offices in Pasadena, we would love to see you. Email me (just hit “Reply” and send me an email) and we will get your lunch request. (Yes, we will feed you!)

Foreign Life Insurance and Americans Abroad

Martha Myron in Bermuda sent me an email with a topic suggestion. It is a good one. This is a tax problem that happens a lot, seems boring (therefore not a tax problem), and yet can make a mess for Americans abroad.

Life insurance. Specifically, life insurance issued by non-U.S. insurance companies. Here is Martha’s suggestion:

USCITS / US green card holders / US tax persons abroad being sold foreign life insurance. You do not have to told the serious misconceptions here, and the hurdles that these individuals have no idea they are going to have to cope with. A recent scenario – the foreign life insurance salesman (selling whole life or variable, of course) told the dual citizen with the US that it was just fine because the individual was earning less than 90,000 under the exemption. Foreign salesperson is not a US CPA / EA or US international tax attorney and actually has never been exposed to any US tax. This might be a topic to add to your PFIC series.

The Problems With Foreign Life Insurance

I am not going to write the Encyclopedia of Foreign Life Insurance, but here are the risks that an American Abroad faces when purchasing a life insurance policy.

Excise Tax

There is an excise tax to pay every time you pay a premium on a foreign life insurance policy, annuity, or sickness and accident insurance.

• 1% of Premium Paid. A U.S. person who buys such a policy is taxed. The tax is 1% of the premium paid.
• Form 720. You are required to file Form 720 to report the premium payment and remit your excise tax.
• Resource. Look at the IRS audit technique webpage for a good overview.

Form 8938

Life insurance and annuity policies with cash value are reportable on this form. They are “specified foreign financial accounts”.

FinCen Form 114

The Dreaded FBAR. Life insurance policies are reportable here, too. 31 CFR § 1010.350(c)(3)(ii).

The PFIC Risk

There is another risk entirely. This is, I think, the risk that Martha pointed out.

In some circumstances, you might have been sold a financial product that is called an “insurance policy”, but from the point of view of the U.S. tax system, it is not an insurance product at all.

If this is the case, you are treated (by the U.S. tax system) as owning an investment account full of assets. That “insurance policy” you bought will contain assets of various types, some of which are almost certainly mutual funds. Foreign mutual funds. These are Passive Foreign Investment Companies, or PFICs. This means:

• You have to file Form 8621 to report all of the mutual funds held as part of the investment account in that insurance policy.
• If, during the time the life insurance policy is active and you are alive, the insurance company buys and sells mutual funds, you will have actual taxable sales under the excess distribution rules.
• When you die, your estate will be treated as having sold the PFICs inside the “insurance policy” for fair market value, again triggering tax under the excess distribution rules.

Estate tax

Worse yet, the death benefit when you die could be taxable.

If this is not an “insurance policy” under the definitions in the Internal Revenue Code, then you have an asset that will be subject to estate tax. The account is just an investment account with stuff in it. When you die it owns the death benefit from the insurance policy. That could be a big number — big enough to cause estate tax problems.

Your heirs, instead of receiving cash tax-free (from the U.S. tax system, that is), will face the possibility of filing Form 706 for you, and paying an estate tax.

Cool

A couple of weeks ago, an unexpected email hit my inbox. A newsletter, it said, would be starting up again after a two-year hiatus.

Read this — an excerpt from the first issue of this revived newsletter. It recounts one of Simo Hayha‘s kills as a WWII sniper in the Finnish Army.

Simo Hayha exhales, his breath showing in the cold air. He shifts his posture, placing as much of his weight as he can against the hard tissue of his body. The small muscles twitch; bone does not twitch.

He looks through the iron sights of his Model 28-30 rifle, closes his left eye, and then re-opens it for depth perception. The Soviet officer is perfectly in the rifle’s trajectory.

The marksmanship instructors always said that the best shot is the one that surprises you. You must pull the trigger so slowly it’s almost a surprise when the gun flares to life. Simo applies gently pressure, unnoticeably tensing the pad of index finger on the trigger, touching it as if he were carefully applying medicine to a young child’s gums, a child that had been crying from new teeth coming in.

The loud crack of the rifle flaring to life shocks Simo, he’s surprised and flinches, but the flinch doesn’t matter – the lead slug has had its gunpowder activated and has already left the rifled barrel.

The bullet’s trajectory is pinpoint-perfect. In milli-seconds, it will strike the invading officer in his breast, near his heart, severing flesh and tendon. The young Russian will crumple sideways into the snow, immediately enter shock, and be on the brink of death before his comrades reach him.

But, wait!

The bullet has not yet struck the Soviet; freeze this landscape in your mind. Simo Hayha is mid-flinch at the surprise of the rifle roaring to life; the young officer is milling about on the cold land, oblivious to the fact that his life is nearing conclusion; the bullet hangs in mid-air, its trajectory set; this scene has almost entirely played out, but not yet; it’s not over yet, we’re at a moment frozen in time.

Who could stop reading at that point?

Here is what I find compelling about the newsletter:

• It is extremely well written. This is not a one-off event. Read anything he has written and you will see the same care and intentionality.
• It contains simple suggestions that you can understand and actually, y’know, do. These things can you make your life better.
• The only way to read the newsletters (at the moment at least) is to sign up. You cannot go to the website and read prior episodes. This is intensely interesting to me as a marketing strategy — that an author would deliberately make it harder for people to find him and his work.

Go to The Strategic Review and sign up. Highly recommended. The author is Sebastian Marshall.

Logging Out

That’s it for this Friday. See you in a couple of weeks.

Remember, this newsletter is not legal advice and you’d be a damn fool to use this newsletter to make tax or legal or life decisions. Go hire someone competent.

Phil.

Hey from Debra Rudd.

You are receiving this message because you are signed up for our “PFICs Only” mailing list, delivered to your electronic mailbox every other Thursday at 6:00 am Pacific time. If you would like to stop receiving this newsletter, just scroll to the bottom of this email and click “unsubscribe”. To see what other newsletters we offer, go to hodgen.com/newsletters.

Work here

We are hiring.

You can see the job listings at hodgen.com/jobs. One admin/office manager, one accountant. We will also be posting a listing for an attorney soon.

For the accountant position, you might be straight out of school or you might have done your tour through the Big 4 or somewhere else and are disillusioned. You want to do international tax work that interests you — instead of junk that some senior partner thinks you should do. And you want a life.

If this sounds like you, please take a look at the listing and consider applying.

PFIC held by a domestic partnership stops being a PFIC

This week’s topic is inspired by a number of questions I received while delivering a speech on PFIC purging elections at the CalCPA International Tax Conference in San Francisco on November 06, 2015:

Jill is a US citizen who purchases an interest in a domestic publicly traded partnership in 2014. The partnership invests in various domestic and foreign companies. On Jill’s 2014 K-1, one of those foreign companies is shown as a PFIC with QEF income information provided. On her 2015 K-1, the company that was shown as a PFIC in 2014 has a note stating that it is no longer a PFIC, and no QEF income information is provided. What does Jill need to do on her 2015 US income tax return?

In today’s newsletter, I will discuss how the QEF election works when a PFIC is held through a domestic pass through entity. Then I will take a look at the rules for reporting income from a QEF that ceases to meet the PFIC definition.

First, a refresher on QEFs

A qualified electing fund (QEF) is a PFIC for which a valid QEF election has been made. Under the QEF rules, a PFIC is taxed similarly to a partnership, meaning that income retains its character (capital gains are taxed as capital gains) and is passed through to the shareholder for current inclusion in income.

You will pay less tax under the QEF rules than you will pay under the punitive Mark to Market rules of IRC §1296 or the extremely punitive excess distribution rules of IRC §1291. You will want to make the QEF election if you can because it has the best tax result for a PFIC.

Partnership makes the QEF election

For PFICs held through pass through entities, the QEF election is generally made by the first US person in the chain of ownership. Regs. §1.1295-1(d)(2).

For a PFIC that is owned by a domestic partnership, an interest in which is owned by a US citizen, the first US person in the ownership chain is the domestic partnership. The domestic partnership makes the QEF election. Regs. §1.1295-1(d)(2)(i)(A).

QEF election only valid if made by partnership

Under Regs. §1.1295-1(b)(3)(iv)(A), the QEF election is only valid for the partners if the election is made by the partnership:

Stock of a PFIC held through a pass through entity will be treated as stock of a pedigreed QEF with respect to an interest holder or beneficiary only if—

(A) In the case of PFIC stock acquired…and held by a domestic pass through entity, the pass through entity makes the section 1295 election…

Note that the QEF election is in effect “only if” the partnership makes the election. Jill cannot herself decide whether to make the QEF election — that is decided at the partnership level.

When she receives the 2014 K-1 from the partnership which provides QEF income information, Jill can assume that the partnership has correctly made a valid QEF election for the PFIC and that she must report it on her tax return as QEF income as directed by the K-1.

If it stops being a PFIC, no QEF income inclusion

PFIC status for a corporation is determined by applying the income test and asset test under IRC §1297(a): if 50% or more of its assets are passive, or if 75% or more of its income is passive, then it is a PFIC.

According to Regs. §1.1295-1(c)(2)(ii), a shareholder of a QEF that ceases to meet either one the two tests does not include income under the QEF rules on her tax return.

That is Jill’s answer: the K-1 states that the company is no longer a PFIC, so she does not have to report income under the QEF rules for that company. When preparing her 2015 tax return, she can assume that any includable income from the former QEF (if there is any) is reflected elsewhere on the K-1.

“Once a PFIC, always a PFIC” rule does not apply

In general, if a company is a PFIC in any year, it continues to be taxed as a PFIC in all future years, regardless of whether it meets the income test or the asset test in those future years. The only way that PFIC status can be terminated is by making a purging election to remove the PFIC status. IRC §1298(b)(1). This is known as the “once a PFIC, always a PFIC” rule.

However, there is an exception for QEFs in that paragraph:

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. IRC §1298(b)(1).

In this scenario, Jill’s PFIC is a qualified electing fund, because the partnership made the QEF election, and Jill is bound by that election.

The “once a PFIC, always a PFIC” rule does not apply to Jill, and she can rely on the regulation that states there is no QEF income inclusion when a QEF ceases to meet the PFIC rules. That result is automatic: she does not need to make a purging election.

If it meets the PFIC definition again, the QEF election applies again

Under Regs. §1.1295-1(c)(2)(ii), if a QEF that ceases to meet the PFIC definition begins to qualify as a PFIC once again in a future year, the QEF election remains in effect and the shareholder is subject to the QEF rules for that future year (unless the election is somehow terminated or invalidated).

If Jill’s PFIC held through the partnership meets the income test or the asset test in some future year (and if the PFIC provides the partnership with the necessary QEF income information), the K-1 will once again reflect the QEF income information she needs to report on her US tax return.

What if the PFIC just disappears from the K-1?

In Jill’s situation, she received a K-1 which explicitly stated that a PFIC which was previously taxed under the QEF rules no longer qualifies as a PFIC. But what if the PFIC just disappears from the K-1? As several CalCPA International Tax Conference attendees pointed out, that is sometimes the case.

In that situation, I’m not sure what the answer is. It could be that the PFIC was sold by the partnership, or it could be that, like in Jill’s situation, the PFIC ceased to meet the PFIC definition. Or, it could be a third scenario: the partnership left an important note off the K-1 in error.

Personally, I would look at the K-1 for clues: does it include notes about other PFICs held in the same partnership, saying that they did not qualify as PFICs in that year? If so, perhaps the PFIC that disappeared without a note was sold. Does it include notes about other PFICs that were sold? If so, perhaps the PFIC that disappeared without a note ceased to be a PFIC in that year.

You may need to contact the partnership for additional information if you cannot determine what happened by process of elimination (I, for one, wouldn’t take anything for granted). Maybe if many people contact the partnership requesting clarification, the partnership will begin to provide better detail on its K-1s in future years. ☺

Thank you

As always, thank you for reading. This is not tax advice to you, and you cannot rely on it as advice. I skipped over a lot of nuances for the sake of brevity and clarity. If you need help, hire a professional.

See you in two weeks.

Debra

Hello from Debra Rudd.

You are receiving this email because you are signed up for our bi-weekly “PFICs Only” newsletter, delivered to your electronic mailbox every other Thursday at 6:00am Pacific time. To stop receiving this newsletter, scroll to the bottom of this email and click “unsubscribe”. On the other hand, if you would like to see the other newsletters that we offer, go to hodgen.com/newsletters.

Is a late MTM election under the inbound immigrant rules possible?

This week’s topic comes from a question I received a while ago from an anonymous reader:

Does an immigrant to the US get to apply the basis step up/transition rule if they did not do a MTM election in their first year of US residence? Can we do it 2 years later?

The answer is “no”, but you can still make the mark-to-market election if you first make a pretend sale under the excess distribution rules. Because the immigrant has not been a US person very long, the actual tax result under the excess distribution rules may not be that bad, relatively speaking, and this could be a viable option.

In today’s newsletter, I will explain why a person new to the US may not use the inbound immigrant transition rule if they do not do it in the first year of US person status. I will then briefly describe the coordination rule for persons making the MTM election after operating under the excess distribution rules. Finally, I will use a specific example to show why the tax results of making the MTM election in the second year of US person status may be a viable option.

Inbound immigrant transition rule only for first year of US status

Our reader (let’s call him A) is referring to a special rule in the Code for inbound foreigners who own PFICs and who want to make a MTM election in the year in which they become US persons. This rule provides for a step-up in basis to fair market value at the beginning of the first year he is a US person (if that market value is greater than his adjusted basis in the PFIC) for the purposes of making the MTM election. IRC §1296(l).

The inbound immigrant transition rule is only available in the year that a person becomes a US person.

If the MTM election is not made in the first year of US person status, then the US immigrant is operating under the excess distribution rules of IRC §1291 for that year. IRC §1291 is the default treatment for PFICs when no elections have been made.

There is no provision for making a retroactive MTM election under the inbound immigrant transition rule.

A cannot make the MTM election under the transition rule two years after becoming a US person.

A can use the “coordination with section 1291” rule

Any person who is operating under the excess distribution rules can transition to the MTM election, assuming that their PFIC meets the marketable stock requirements of IRC §1296(e) and they are otherwise permitted to do so under the Code and regulations. Let’s assume that A owns marketable PFIC stock and is otherwise permitted to make the MTM election.

Under IRC §1296(j), coordination with section 1291 for first year of election, when A makes the MTM election in the second year of US person status, he is subject to a special set of rules that include gain recognition under the excess distribution rules:

• The entire first year of the MTM election, any distributions or actual sales are taxed under the excess distribution rules, not the MTM rules;
• At the end of the first year of the MTM election, A must make a pretend sale and recognize the gain under the excess distribution rules; and
• A does not get to operate under the MTM rules until the second year of his MTM election.

For a more detailed explanation of how this works, see a blog post I wrote last year on that topic.

Tax results under the “coordination with section 1291” rule

Let’s use the following scenario to determine the tax results if A makes the MTM election under the coordination rule of IRC §1296(j) in the second year of US person status:

A, a nonresident, purchases a foreign mutual fund which qualifies as a PFIC on January 1, 2008. A never makes any subsequent purchases or sales, and never receives any distributions from the fund.

A becomes a US resident under the substantial presence test in 2014, so the first day of A’s US person status is January 1, 2014.

A fails to make the MTM election under the inbound immigrant transition rule for 2014.

A decides to make the MTM election under the coordination with section 1291 rule for 2015.

A computes his gain on the deemed sale as of December 31, 2015 to be $1,000.

I will assume that readers are familiar with the excess distribution rules while going through the calculations. For those not familiar, go here for a primer in excess distributions.

Step 1: Allocate the gain over the holding period

The holding period is 8 years exactly, starting on January 1, 2008 and ending on December 31, 2015. Ignoring the extra day in leap years, A can allocate $125 of gain to each of the 8 years ($125 x 8 = $1,000).

Step 2: Separate holding period into pre-PFIC, prior years’ PFIC, and current year periods

Now we must separate the gains into three periods: the pre-PFIC period, the prior years’ PFIC period, and the current year.

The pre-PFIC period includes all the time that A was a nonresident of the US, according to Prop. Regs. §1.1291-1(b)(1)(i):

A corporation will not be treated as a PFIC with respect to a shareholder for those days included in the shareholder’s holding period before the shareholder became a United States person within the meaning of section 7701(a)(30).

Therefore, the amounts allocated to each period are as follows:

• Pre-PFIC period: From January 1, 2008 to December 31, 2013 (6 years). 6 x $125 = $750.
• Prior years’ PFIC period: From January 1, 2014 to December 31, 2014 (1 year). 1 x $125 = $125.
• Current year: From January 1, 2015 to December 31, 2015 (1 year). 1 x $125 = $125.

Step 3: Determine ordinary income

Under the excess distribution rules, the amounts allocated to the pre-PFIC period and the current year are ordinary income. That means in this example A has $875 of ordinary income.

Step 4: Calculate tax and interest on prior years’ PFIC income

$125 of the gain is allocated to the prior years’ PFIC period. Tax is computed on that amount at the maximum tax rate for the year. For 2014 that is 39.6%.

A’s tax on the amount allocated to 2014 is $125 x 39.6% = $49.50.

A must compute interest on the tax he calculated as if it was an underpayment of tax due on the tax return due date of the tax year to which the tax was allocated, and the interest runs through the due date of the tax return on which he is reporting the excess distribution. IRC §1291(c)(3).

For A, that means he computes interest on $49.50 of tax from April 15, 2015 to April 15, 2016. I calculated the interest to be $1.51.

Recap of tax results for A

To recap, if A makes the MTM election under the coordination with section 1291 rules in his second year of US person status, and computes his gain to be $1,000, the tax he will face will be the following:

• Ordinary income of $875, assuming a tax rate of 30% = $262.50
• PFIC tax and interest on amount allocated to prior years’ PFIC period = $49.50 + $1.51 = $51.01
• Total tax as a result of the election = $262.50 + $51.01 = $313.51

Some comments on this strategy

Note that, had A been able to make the MTM election under the inbound immigrant transition rule, the entire gain would have been ordinary income (and according to my calculations that means $13.51 less tax to pay, assuming a gain of $1,000).

Of course, he would have been able to use a stepped-up basis under the inbound immigrant transition rule, so the gain would have been smaller than the $1,000 we are dealing with here, and the tax savings could have been quite a bit more than $13.51.

However, I would like to point out that the interest charges only apply to one year of A’s holding period when using the method I described here, so he will at least not be subject to years upon years of accumulated interest.

While it is not the best tax result he could have had, it may be worth it to make the MTM election under the coordination with section 1291 rules if he plans to continue to hold the fund for a significant period of time and plans to continue to be a US person. In the long run, the MTM election will be better for him than the default PFIC treatment.

He can consider the extra tax he pays by failing to make the MTM election in the first year the “oops” tax. I personally pay an “oops” tax somewhat frequently in life because I am human and I make mistakes.

Thank you

As always, thank you for reading this week’s edition of PFICs Only. I hope that you found something useful in it, but please do not rely on this as legal or tax advice (and hire a professional if you need help).

See you in two weeks.

Debra

Hello from Debra Rudd.

You are receiving this email because you are signed up for our PFICs Only newsletter, delivered to your electronic mailbox every other Thursday at 6:00 am Pacific time. To stop receiving these emails, scroll to the bottom and click “unsubscribe”. To see what other newsletters we offer, go to hodgen.com/newsletters.

Applying the look through rules to figure out if you have a PFIC

This week I will take a look at the following anonymous question I received:

I have shares in a foreign family holding company which buys shares in various foreign businesses. I am not sure if it is a PFIC. What information do I need to ask for to figure out if it is a PFIC?

In today’s newsletter, I will discuss how to apply the PFIC look through rules in conjunction with the PFIC definition to determine whether the family holding company is a PFIC or not.

Some assumptions about Holding Co

I am going to call it “Holding Co” rather than “the family holding company” because, well, I like proper nouns.

I will assume Holding Co is taxed as a corporation under US tax law. If it is not taxed as a corporation, it cannot be a PFIC.

I will further assume that Holding Co has bought shares in two businesses: Business A, of which it owns 10% of the shares, and Business B, of which it owns 40% of the shares. I will assume both businesses are taxed as corporations under US tax law.

I will assume that neither Business A nor Business B paid out any dividends to its shareholders.

Lastly, I will assume that our reader is the only US person owner of Holding Co, and I will assume that she owns less than 10% of the shares of Holding Co so that no Form 5471 filing requirements will be triggered.

PFIC Definition

A foreign corporation is a passive foreign investment company, or PFIC, if it meets either the income test or the asset test.

The income test says that if 75% or more of its income is passive, then it is a PFIC. IRC §1297(a)(1).

The asset test says that if 50% or more of its assets are passive, then it is a PFIC. IRC §1297(a)(2).

This rule applies no matter what type of entity you are analyzing as it is classified under local law (whether mutual fund, unit trust, hedge fund, startup company, etc.), as long as it is a foreign entity that is taxed as a corporation under US law.

There is nothing particularly mysterious about it. It requires an understanding of what counts as “passive” income and assets, an income statement, a balance sheet, and an Excel sheet or a calculator and some scratch paper.

Look through rule for subsidiaries

Some complication could arise, however, when the entity you are analyzing makes investments in other entities.

If the company owns 25% or more of the stock of another corporation, then that company is treated as receiving its proportional share of the income and owning its proportional share of the assets of that other corporation. IRC §1297(c). This is known as the PFIC look through rule.

The effect of the PFIC look through rule is that a parent company will be attributed its proportional share of the assets and income of its 25% or more subsidiaries when applying the PFIC definition.

In other words, when a company has a 25% or more interest in a subsidiary, you apply the look through rule first before applying the income and asset tests to determine if it is a PFIC.

A company that would not otherwise meet the income test or the asset test, and therefore would not qualify as a PFIC, could end up being a PFIC because of this rule. Conversely, a company that would in itself be a PFIC and owns shares in an active business could end up not being a PFIC because of this rule.

The look through rule only applies to Business B

In our example, Holding Co owns 10% of Business A, so it does not meet the minimum requirement for taking Business A’s income and assets into the calculation. Holding Co must own 25% or more of the shares of the subsidiary company for the rule to be in effect.

However, Holding Co does meet the minimum requirement for taking Business B’s income and assets into the calculation for Holding Co’s PFIC status, owning 40% of Business B’s stock.

Applying the PFIC tests to Holding Co

To determine if Holding Co is a PFIC, you need to have the financial statements of Holding Co, and because you have to apply the look through rule to Business B, you also need to have the financial statements of Business B.

When you are applying the PFIC tests, you will need to separate passive income from non-passive income, and passive assets from non-passive assets. You will do this to the income statement and balance sheet for both Holding Co and Business B. (For brevity I am assuming readers are familiar with what are considered passive assets and passive income for the purposes of these tests).

Then you apply the proportional interest that Holding Co has in Business B. Holding Co owns 40% of Business B, so multiply all the numbers from Business B by 40%.

The income test

Add together the passive income from Holding Co and 40% of the passive income from Business B that you just calculated. That gives you Holding Co’s passive income for purposes of the income test.

Add together the non-passive income from Holding Co and 40% of the non-passive income from Business B that you just calculated. That gives you Holding Co’s non-passive income for purposes of the income test.

Compute the total income by adding the results of the last two steps. Then figure out whether passive income makes up 75% or more of the total.

If so, you can stop now. It is a PFIC. Remember that you only need to meet one of the two tests for it to be a PFIC.

If Holding Co does not meet the income test, go on to see if it satisfies the asset test.

The asset test

Add together the passive assets from Holding Co and 40% of the passive assets from Business B that you just calculated. That gives you Holding Co’s passive assets for purposes of the asset test.

Add together the non-passive assets from Holding Co and 40% of the non-passive assets from Business B that you just calculated. That gives you Holding Co’s non-passive assets for purposes of the asset test.

Compute the total assets by adding the results of the last two steps. Then figure out whether passive assets make up 50% or more of the total.

If so, you have a PFIC.

If not, and if it did not meet the income test, Holding Co is not a PFIC for the year you are looking at.

A brief aside about the asset test

One thing that should not go without mention is that cash is considered a passive asset for the asset test.

Additionally, you must look at the fair market value of assets when computing the value for PFIC determination purposes. Some financial statements show fixed assets and intangibles brought to fair market value each year, but some do not.

Furthermore, intangibles such as goodwill, trade secrets, patents, and copyrights are sometimes not shown on the balance sheet at all when they are developed internally.

It may not be as simple as merely looking at a balance sheet: where a company has an unrecorded non-passive intangible, or where assets are not brought to market value on the balance sheet, it could mean the difference between “PFIC” and “not a PFIC”. For example, a company with a large cash balance and an even larger unrecorded non-passive intangible could appear to be a PFIC when you look at the balance sheet but may in reality not be a PFIC.

If you are aware of these issues when applying the asset test, and if you have some basic information about how the financials were prepared and whether the company has any intrinsic value that may not be reflected on the balance sheet, you will be much more likely to arrive at the correct answer.

Once a PFIC, always a PFIC

It is not sufficient to perform the income test and asset test calculations for only one year. You must do it for each year that you own Holding Co to be sure it is not a PFIC.

According to IRC §1298(b)(1), if a company was a PFIC previously in your holding period, it continues to be taxed as a PFIC for you now and in the future. This is known as the “Once a PFIC, always a PFIC” rule.

That means that if you bought shares in Holding Co in 2008, for instance, and you just recently learned about PFICs, you should do the calculations described above for each year of your holding period.

If it qualified as a PFIC for you in the past, it will continue to qualify as a PFIC in the current year, even if it does not meet the income test or the asset test for the current year.

You may have the option of making a purging election if it was a PFIC in the past but no longer meets the PFIC definition, and the purging election may even be available retroactively, but that is a topic for another time.

The calculations can get complicated

Applying the look through rule over a period of multiple years for multiple subsidiaries can be a lot of work. It can be even more work where the company regularly buys and sells shares in the subsidiaries and there is a great deal of change within the structure.

The most difficult aspect of it can be staying methodical and staying organized. It may be helpful to create an organization chart of the structure at each year end with notes about all the transactions you need to be aware of and possibly report, and by doing so you can isolate the issues and approach them one by one.

Based on the information I have, it sounds like Holding Co probably does not have a lot of activity and the level of complication that goes with it; I am waiving this flag of caution only because I have seen similar structures that do and it can be very difficult to figure out what is a PFIC and what is not.

My guess is that Holding Co is not a PFIC

If Business B is an active operating business, chances are that it has mostly non-passive income and assets, which will all be attributed to Holding Co via the look through rule.

Holding Co itself probably does not have a lot of assets other than Business A and Business B and some cash, and probably does not receive a lot of income.

I would guess that the total non-passive income attributed from Business B is probably enough to prevent Holding Co from meeting the income test, and I would also guess that the total non-passive assets attributed from Business B are enough to prevent Holding Co from meeting the asset test.

These are just guesses, of course – it is necessary to do the math and figure out the answer.

Thank you

Thank you, as always, for reading. Please send me any PFIC questions you have by clicking “reply” to this message.

Obligatory disclaimer: Do not rely on this newsletter as legal or tax advice. Hire a professional if you need help.

See you in two weeks.

Debra