Foreign Nationals & Expats
Houston Tax Attorney
Do you Invest in a Passive Foreign Investment Company?
Many taxpayers with overseas investments may unknowingly have one or more investments in a passive foreign investment company (PFIC). And chances are highly likely that these investments are not being reported correctly. Taxpayers don’t know what they are and even their CPAs may not be familiar with these investments.
History of PFICs
A US shareholder is taxed on his share of a US corporation’s net ordinary income (dividends and interest) and capital gains. US mutual funds are required to provide shareholders with an allocation of their ordinary income and capital gains. Additionally, this information is reported to the IRS on Form 1099-B.
Foreign mutual funds on the other hand usually do not provide such allocations to shareholders. Consequently, the income that would’ve been reported in the US as ordinary dividends or interest income can be tax deferred when the same type of income is earned through a foreign mutual fund. Not only is this income tax deferred, it’s also converted into capital gains which are taxed at a preferential rate.
In order to prevent massive capital outflow and protect US companies, Congress enacted the passive foreign investment company (PFIC) regime in 1986 and is codified in IRC § 1291 to 1298.
Do I have a PFIC?
A PFIC can be found in any non-US investment that contains foreign mutual funds. Such investments can include ownership in the following types of investments:
- Non-US mutual funds
- Hedge funds
- Insurance products
- Money market accounts
- Pension funds (except foreign grantor trusts such as a Canadian RRSP or self-funded U.K. SIP)
Usually taxpayers with the above investments will have several to dozens of PFICs within these investments.
How Does this Impact me Financially?
First, the PFIC taxing regime is highly punitive for such investments compared to similar types of investments in the US. For those in the highest marginal tax bracket with “excess distributions” could end up paying taxes in excess of 50% of their investment income.
Second, if you’re able to find a tax practitioner who understands PFICs, your professional fees may increase by thousands even for just a few PFIC investments. The IRS estimates the time to prepare a PFIC form to be 7 hours. Let’s say you have an investment account that has investments in 5 foreign investment funds. Each one of those funds is a separate PFIC and requires separate reporting, resulting in 35 hours of prep time, including research and information gathering. Moreover, for each PFIC you’ll have to obtain the previous 3 years of statements (if applicable).
But I’ve had these Investments for a Long Time…
…and my CPA never told me about them. Consider yourself fortunate. While I have yet to see an IRS letter inquiring about a PFIC investment, be aware that mandatory Form 8621 filing requirements only went into effect in 2014 (2013 returns and onward).
My advice to anyone who owns a PFIC would be to liquidate these investments and invest through US mutual funds. There’s a way to avoid the punitive “excess distribution” taxes by making a timely MTM or QEF election. However, compliance costs and the risk of incorrect reporting will likely wipe out any gains from these investments.