PFIC (Passive Foreign Investment Companies)
When it comes to international reporting of foreign accounts, assets, investments, and income — one of the most complicated aspects involves the reporting of PFICs. A PFIC refers to a Passive Foreign Investment Company and what makes it so complicated is simply how broad the definition can be. For example, if a person creates their own foreign corporation that is used to generate dividends and capital gains—then it would be considered a PFIC. Conversely, even when a person simply invests in a foreign mutual fund, that too can be considered a PFIC. In the first instance, the person is proactively creating a company with the understanding that they are designing their own entity to generate passive income (which is an intentional act). In the second scenario, the person is simply investing in a foreign mutual fund to avoid creating their own investment structure, and it is usually done without regard or concern about reporting this investment as PFIC. Beyond the complications with reporting a PFIC is the issue of the tax rules, which are also incredibly complicated, especially in any year that the person has an excess distribution. Let’s take a look at five introductory facts about a PFIC.
What Is a PFIC? Form 8621?
A PFIC is a Passive Foreign Investment Company. US taxpayers are required to report their PFIC on Form 8621. Unlike other forms such as Form 8938, Form 8621 is required to be filed even if the taxpayer does not have a tax return filing requirement. It operates similarly to the FBAR in that regard. In order to qualify as a Passive Foreign Investment Company, it must meet either the Income Test or the Asset Test, but not both. In order to meet the Income Test, at least 75% or more of the income must be considered passive income as defined under Internal Revenue Code section 1297(b). Alternatively, under the Asset Test, at least 50% of the average percentage of assets are held for the production of passive income.
No Majority Ownership Required
Unlike other international information reporting of foreign companies, a US person does not have to own at least 50% of the PFIC in order to have to disclose the information to the Internal Revenue Service. Rather, fractional ownership may still require the filing of the form. Although, there are some exceptions such as if the person has less than $25,000 or $50,000 MFJ and no excess distributions. There is some discrepancy between the instructions (which appears as though the top part of Form 8621 is still required) and the regulations (in which it appears there would be no Form 8621 reporting required for this exception).
Distributions vs. Excess Distributions
When a person has excess distributions from a PFIC, reporting becomes infinitely more complicated. Depending on whether the excess distributions originate from capital gains or dividends will impact the complexity of the analysis and equation. For the most part (especially when dividends are involved), it is typically a hybrid distribution/excess distribution calculation in which the excess distribution is taxed at the highest tax rate (other than the current year in which it is taxed at the progressive tax rate).
Elections and Late- Elections
In order to try to minimize the tax implications of having a PFIC, the taxpayer can make an election to be treated as either a Mark-to-Market or Qualified Electing Fund. The latter is the preferred election (due to the tax benefit it can provide) although it requires significant information from the foreign investment company, which may not be viable and quite frankly may lead to the foreign investment company wanting to remove you (the US taxpayer) from the investment because they simply do not want to deal with the headache of having a US person as part of the investment, especially when that requires the FFI to comply with US FATCA reporting. If a person misses the initial window of time to make the election, they can try to make a retroactive election with reasonable cause (but there are very strict requirements to do so and it is difficult to qualify for). In the alternative, they can make a late election also known as a purging election, where they will need to “cleanse the taint,” but this can be a complicated, costly process and may result in a significant tax liability.
Failed to Report the Form 8621 and Interplay with Form 8938
When a person fails to report the PFIC on Form 8621, the penalty primarily consists of the fact that the tax return does not close in the typical 3- to 6-year statutory window. But, another issue to consider is if Form 8621 is not filed and the IRS does not know it is a PFIC, the IRS may just presume it is a FATCA reporting asset and since the 8621 was not filed, the taxpayer may get hit with Form 8938 penalties.
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