Passive Foreign Investment Companies – A primer on excess distributions from PFICs

by Laura Johnson, EA

I don’t like PFICs. In my experience as a tax professional, they cause our clients and staff a bunch of headaches. US taxpayers can invest in any asset class without using high-cost, high-tax PFICs. It is rare that the return on investment justifies the cost. However, some Americans inherit PFICs, or are exposed to them through partnerships, trusts, or other structures. It’s important to be able to identify PFICs when they appear and to understand what makes them special in the US tax system.

What is a PFIC?

A PFIC is a Passive Foreign Investment Company. What does that mean? It means that the company is a foreign (non-US) corporation, where more than 75% of the income is of a passive type (from investments), or where the assets are more than 50% passive (like it holds a bunch of cash and securities, not machinery and equipment). A foreign-issued mutual fund is a classic example.

Why are foreign mutual funds (PFICs) worse off than US mutual funds?

PFIC stock receives disadvantageous tax treatment in the US tax code. The default treatment is particularly poor. Current year distributions are taxed at ordinary rates. In a year you receive an excess distribution “E.D.”, you will pay tax at the top marginal tax rate for that year, PLUS pay an interest charge on the E.D. Then you are going to pay a competent tax advisor to help you calculate all this stuff.

Or you could invest in a US-issued mutual fund where distributions would likely be taxed at preferential capital gains rates with no fancy math required. If you have the choice, the US-issued option is probably superior.

What is an excess distribution?

A distribution (typically a dividend the fund pays its shareholders) that exceeds 125% of the average distribution over the past three years is an excess distribution. These rules apply to EVERY (read small and large) PFIC that makes distributions.

Here is an example of how that works.

Alex owns a PFIC. In years 1, 2, and 3 Alex received a $100 dividend from the fund. In year 4, the PFIC pays Alex a $200 dividend. 125% x the 3-year distribution average (125% x (3*$100/3)) = $125. Alex has an excess distribution of $75 ($200 - $125) in year 4. $125 gets taxed as an ordinary dividend (not as a “qualified dividend” with a favorable rate). $75 gets taxed at the highest marginal tax rate for year 4, plus an interest charge.

Is it ever that easy in the real world? No, of course not. Practically speaking, on top of needing to possess or acquire 4 years of distribution records from the fund, you have to do a bunch of math on Form 8621 (that is a special IRS form for PFICs), just to figure out how much tax you owe.

Oh yeah, and if you are fortunate enough to hold a big investment portfolio with lots of PFICs you get the pleasure of calculating this on a fund-by-fund basis. Not on an account-by-account basis.

Tell me more about this interest charge

The interest charge is based on your holding period. The longer you hold the PFIC, the larger the interest charge. As with many issues, this problem gets worse, not better with time.

Parting thoughts

This is the default method for taxing PFICs. There are elections a taxpayer can make which can reduce PFIC taxes. However, it is my opinion that in many instances, PFICs are not efficient, or appropriate investments for the US-based taxpayer. Replace your PFICs with similar US-based funds and save yourself taxes and professional fees.

At John Schachter + Associates, Inc., we help clients calculate PFIC taxes and manage their PFICs efficiently. Let us know if we can help you!