Liquidating distribution from a PFIC
This is a question I received in an email:
I invested in a PFIC. The PFIC decided to liquidate. It sold all its investments, paid its major liabilities, then paid most of the cash proceeds to its investors. Then, after paying miscellaneous, small debts and winding up its business, it distributed the remainder of its cash to the investors. I lost money on the investment. Do I have to pay PFIC tax on the distributions?
This post describes why both the first and second distributions are treated as proceeds from the sale of the investor’s PFIC shares, and why only the gain over investment is subject to tax.
Background on PFICs and how they are taxed
Passive foreign investment company (PFIC) is a special classification for foreign corporations under the Internal Revenue Code. We assume that the investor is a US person, and he has invested in a PFIC.
By default, proceeds from PFICs are subject to 2 sets of rules.
When a PFIC makes a distribution to a shareholder, the distribution is separated into excess distribution and non-excess distribution. The non-excess distribution may comprise dividends, return of basis, and capital gains as normal. The excess distribution is subject to tax, even if it is entirely return of basis. IRC §1291(a), (b); 301(c). Exactly how the tax is calculated is beyond the scope of this post, but an important item to note is that if a distribution is taxed as an excess distribution, then even return of basis, which is normally tax-exempt, is taxable.
When a shareholder realizes a gain from disposing of a PFIC share, the entire gain is taxed as excess distribution. IRC §1291(a)(2). But the way we calculate gain follows the normal rules: Gain equals amount realized minus adjusted basis. IRC §1001. Thus, if a distribution is taxed as a sale of a PFIC, then the return of basis is not taxable.
We need to know whether the 2 distributions from the PFIC undergoing liquidation is subject to the rules of distribution or gain.
Liquidating distributions are normally treated as proceeds from sale
When a shareholder receives a distribution in complete liquidation of a corporation, the distribution is treated as full payment in exchange for stock. IRC §331. This is a special treatment for liquidating distributions, so the transaction is treated as if the shareholder sold the shares in exchange for the liquidating distribution.
Normal rules for calculating gain or loss apply. IRC §331(c). Gain equals amount realized minus adjusted basis. Thus, a portion of the amount realized equal to the adjusted basis (the return of basis) is not gain and is not included in income.
It is possible for a corporation to make a series of liquidating distributions, each of which is treated as a payment in exchange for the shares. Olmsted vs Commissioner, TC Memo 1984-381. As long as the corporation is in a state of liquidation, each of the distributions during the state of liquidation is a liquidating distribution under section 331. Olmsted, TC Memo 1984-381, 22.
Whether a corporation is in a state of liquidation is a question of fact. In our case, the facts are simple. The PFIC sold all its investments, paid its major liabilities, then distributed most of the cash to its investors. Then, after paying small liabilities and formally dissolving, it paid the remaining cash to the investors.
This is a classic case of liquidation, and there is little question that both the initial large cash distribution and the following remainder cash distribution would be liquidating distributions had the corporation been a normal corporation rather than a PFIC. The question is whether the PFIC rules override the liquidating distribution rules.
You get liquidating distribution treatment
The IRS has not adopted any regulations on this matter, but the proposed regulations are fairly clear: Liquidating distributions are treated dispositions of the PFIC shares, not distributions in respect of shares; and a series of liquidating distributions is treated as a series of dispositions on each liquidating distribution date. Prop. Treas. Reg. §1.1291-3(h).
If you determine that a PFIC is liquidating, treat each liquidating distribution as payment in exchange for the shares. When the payment results in a gain according to the normal methods of calculating gain, you recognize gain and calculate tax on the gain under PFIC rules on the date of distribution.
In our scenario, it is clear that the PFIC is liquidating. Thus, the first cash payment is treated as payment in exchange for the PFIC shares. Because our investor lost money on the investment, I assume the payment is less than his adjusted basis in the PFIC shares. Thus, there is no gain. Likewise, the second cash payment is treated as payment in exchange for the PFIC shares. Because our investor lost money on the investment, I assume the payment is still less than his adjusted basis in the PFIC shares–after the reduction from the first payment.
Fortunately, our investor does not need to pay tax on the losses from the PFIC liquidation. As far as I know, there is no special rule for treating losses from the sale of a PFIC. Most likely, the investor has a capital loss.
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