PFIC Rules & Late Form 8621: Understanding Your IRS Compliance Options

The passive foreign investment company (PFIC) rules are complex and nuanced. Generally, a U.S. shareholder with a PFIC interest must pay federal income tax on “excess distributions” received from the foreign corporation unless the shareholder has timely elected out of the PFIC regime. Because excess distributions are treated as earned ratably over the shareholder’s PFIC holding period and not solely in the year of the distribution, the shareholder’s failure to make an available election can be expensive.

U.S. shareholders miss the PFIC election deadlines for numerous reasons. For example, they may be unaware of the PFIC rules generally. Alternatively, they may understand the PFIC rules but lack sufficient information to determine whether the foreign corporation should be characterized as a PFIC. Unfortunately, the governing federal income tax rules make it difficult to seek retroactive relief, resulting in significant tax consequences associated with the shareholder’s future receipt of distributions or the sale of the PFIC stock.

Passive Foreign Investment Companies

To qualify as a PFIC under federal income tax law, a U.S. shareholder must have an interest in a foreign corporation that satisfies either an “income test” or an “asset test.”

There are numerous ways that a foreign entity can be characterized as a corporation for U.S. tax purposes. These include:

• The entity falls within the per se corporations listed in Treas. Reg. § 301.7701-2(b)(8).

• Under the “check-the-box” regulations, all of the entity’s owners have limited liability under governing federal law.

• Under the “check-the-box” regulations, the entity qualifies to make an election to be treated as a corporation and makes the election (IRS Form 8832).

If the entity is a foreign corporation, the next step is to determine whether it is a “controlled foreign corporation” or CFC. Generally, CFCs are not subject to the PFIC rules because CFCs are subject to other anti-deferral rules (e.g., subpart F). For these purposes, a CFC is a foreign corporation owned more than 50% by U.S. shareholders who, in turn, own at least 10% or more of the foreign corporation’s stock.

Example: John, a U.S. citizen, owns 100% of a Public Limited Company (PLC) in Ireland. Because PLCs are per se corporations under Treas. Reg. § 301.7701-2(b)(8), the PLC is a foreign corporation. Because John, a U.S. citizen, owns more than 50% of the foreign corporation (and John’s ownership consists of 10% or more of the foreign corporation’s stock), the PLC is a CFC for U.S. tax purposes.

Example: Sara, a U.S. citizen, owns 7% of a PLC in Ireland. No other U.S. citizens or residents have an ownership interest in the PLC. Because PLCs are per se corporations, the PLC is a foreign corporation. However, because no U.S. person owns more than 50% of the PLC, it is not a CFC. Whether Sara has an ownership interest in a PLC depends on whether the PLC meets the income or asset test discussed below.

Foreign corporations that satisfy the income or asset test are PFICs. Under the income test, a foreign corporation that earns 75% or more of its gross income from passive sources is a PFIC. Generally, passive income means dividends, interest, royalties, annuities, and capital gains.

Under the asset test, a foreign corporation may alternatively be characterized as a PFIC if it holds 50% or more of its total assets for the production of passive income (e.g., stocks and bonds). If the foreign corporation is not publicly traded, the measurement is made usually each quarter based on the adjusted basis of the corporation’s assets. Conversely, foreign corporations that are publicly traded must use fair market values.

The income and asset test is made each tax year. Therefore, it is not unusual for a foreign corporation to be treated as outside the PFIC regime one year but within the PFIC regime the next year. Moreover, because foreign mutual funds usually satisfy the income and/or asset test, these funds are almost always characterized as PFICs for U.S. tax purposes.

Example: Same facts as above concerning Sara and her 7% ownership interest in the PLC. In 2023, the PLC conducts manufacturing activities and therefore earns most of its gross income from a manufacturing trade or business. Also in 2023, the PLC holds primarily machinery and equipment and no passive-income earning assets. In 2024, however, Sara sells the business in an asset sale and invests the funds in foreign stocks and certificates of deposit. Here, the PLC is not a PFIC for 2023 but will likely be characterized as a PFIC for 2024 due to the passive income and passive-income generating assets it holds.

Excess Distributions

Congress enacted the PFIC regime to penalize U.S. taxpayers for making passive investments in foreign corporations. Although the PFIC rules permit the deferral of passive income from these investments, the deferral comes with a price. Specifically, when a U.S. shareholder has an excess distribution from the PFIC, the shareholder must pay income tax at the highest ordinary income tax rates with a deemed interest charge.

The PFIC rules define an excess distribution as a PFIC distribution that exceeds 125% of the average distributions received in the three prior tax years. The sale of a PFIC interest also constitutes an excess distribution. If a U.S. shareholder receives a PFIC distribution or sells PFIC stock, the shareholder must compute the U.S. tax liability associated with the distribution via three steps.

• Step One: Allocation of Distribution. First, the shareholder must treat the distribution as received ratably over each day that the shareholder held the PFIC interest. For example, if the shareholder acquired a PFIC interest on January 1, 2021, and received an excess distribution on December 31, 2025, the shareholder would be treated as receiving the distribution on a pro rata basis each day from January 1, 2021, through December 31, 2025.

• Step Two: Taxes on Deemed Distributions. Next, the shareholder must determine the federal income taxes associated with the deemed pro rata distribution. Under the PFIC regime, the distributions are treated as ordinary income subject to the highest marginal tax rates for each applicable tax year. The sum of the income tax for all of these years is treated as an increase in tax for the year the PFIC made the excess distribution.

• Step Three: Deemed Interest Charge. After the first two steps are completed, the shareholder must compute the interest charge. For these purposes, the shareholder is deemed to owe the income tax liabilities in step two above as of the tax filing deadline for each applicable year. In our example above, the shareholder would have to pay an interest charge on the pro rata distribution deemed made in 2021 as if the income taxes were due on April 15, 2022. The shareholder would have to make similar interest computations for 2022 through 2024.

These computations are required on IRS Form 8621. The failure to file an IRS Form 8621 does not result in a penalty but does cause the statute of limitations for the IRS to make an assessment related to any excess distribution to remain open indefinitely until the shareholder files the form (and for three years after filing).

PFIC Elections

The PFIC rules are punitive, particularly if the U.S. shareholder held the PFIC interest for an extended period of time. To avoid these punitive tax consequences, eligible shareholders can elect out of the default PFIC rules by making a timely qualified electing fund (QEF) election or a mark-to-market (MTM) election. The election is made on IRS Form 8621.

If a U.S. shareholder makes a timely QEF election, the shareholder is treated similarly to a partner of a partnership for U.S. tax purposes. Specifically, the U.S. shareholder must report its allocable share of PFIC income items on its return each year. The QEF election therefore permits the shareholder to report capital gains from the PFIC (unlike the ordinary income tax treatment of the default PFIC regime). To qualify for the QEF election, the PFIC must agree to provide the U.S. shareholder with sufficient information to properly report the shareholder’s allocable share of PFIC items each year.

Under the MTM election, U.S. shareholders are deemed to sell their PFIC interests at the end of each tax year and report the corresponding gain as ordinary income. If the deemed sale results in a loss at the end of the tax year, the shareholder may utilize the loss only to the extent it reverses prior income inclusions. Although the shareholder must recognize ordinary income each year, absent deemed MTM losses, the shareholder does not have to pay an interest charge as it must otherwise do under the default PFIC regime. To qualify for the MTM election, the PFIC must be listed on a publicly traded exchange (i.e., the MTM election is not available for private companies).

Options For PFIC Non-Compliance

As mentioned earlier, the PFIC rules are complex and not well known by taxpayers and sometimes their tax professionals. Therefore, it is common for U.S. shareholders to miss making a timely QEF or MTM election. It is also common for taxpayers with PFIC interests to fail to file an IRS Form 8621 to report excess distributions.

Thankfully, there are some compliance options for taxpayers in these circumstances. As an initial matter, U.S. shareholders should consider the IRS’ Streamlined Filing Compliance Procedures (SFCP). If the shareholder missed many years of reporting excess distributions and was non-willful in failing to file the IRS Form 8621, the shareholder can potentially utilize the SFCP to close the open statute of limitations on assessment for prior years and regain compliance. If the taxpayer does not qualify for the SFCP, other avenues may be available, including the IRS’ Voluntary Disclosure Program (VDP) if the taxpayer’s conduct was willful in failing to report the excess distributions and/or file the IRS Form 8621.

U.S. shareholders who have held PFIC interests and have not received excess distributions also have options, although time is usually of the essence here. As discussed above, the deemed interest charge continues to accrue each year the shareholder holds ownership in a PFIC. In certain instances, the shareholder may qualify for retroactive relief through request of a Private Letter Ruling (PLR). In other cases, the shareholder may consider “purging” the PFIC taint and making an election that will carry forward to avoid punitive tax consequences in subsequent tax years.

For any questions about this blog post or any other legal or tax-related matter, please feel free to contact mroberts@meadowscollier.com.