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:
- 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.
- 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