Got PFIC’s in your overseas portfolio? This one is for you.
In today’s post, I’ll discuss the passive foreign investment company (PFIC). I’ll address the origin (briefly), the taxation, and how you can tell if there is a PFIC lurking in your overseas accounts or not.
I’ll conclude with how to think about them if they are a part of your overseas portfolio.
This is key if you are a US tax resident, which is not the same as your immigration status.
What’s In Your Overseas Portfolio?
One of my questions for those who reach out to discuss working together is, “What assets do you have overseas?”
I pay attention to the answers, and when Investment/Retirement accounts come up, I dig deeper. And they come up a lot.
Typically, the prospect will mention the account type or the account name or try to describe it in a way that makes “US” sense.
Here are some examples of what prospects have provided (in their own words) and what they call them back home.
Foreign Accounts That May Hold PFICs
Demat Accounts, KiwiSaver, Super account, TFSA, MMF account, CDS account, an investing ISA, AFORE account, etc.
Many of these accounts hold assets that are deemed to be PFICs (Passive Foreign Investment Companies).
And this is where we start to get into trouble because of how the IRS taxes them. It’s excessive, punitive, and the paperwork involved is a nightmare (complex and takes too much time).
Let’s dive into the details of PFICs, including a brief history, tax implications, and how to tell if a PFIC is lurking in your overseas accounts.
Why Are Foreign-Born Families Investing Outside The US?
With foreign-born families, I completely get and understand investing outside the US. This applies to those on work visas, green card holders, or citizens.
For some of you, these are your old retirement accounts (after all, you were working and saving in your home country’s workplace/government accounts, before moving to the US).
For others, this is where you were investing before moving to the US.
Some of you are trying to diversify, you also believe the returns are better in your home country, and of course, there is home bias.
Finally, there are those who have inherited the accounts after their elders passed away.
Regardless, PFICs can and tend to be highly problematic under the Internal Revenue Code.
Let’s start by defining a PFIC.
PFICs Explained: What’s A PFIC?
Investopedia defines a PFIC as a foreign corporation that meets either one of the following conditions. The two conditions or tests are the “income test” or the “asset test.”
The Income Test
The “Income test” – 75% or more of its gross income is passive, which means the income is coming from investments or sources not related to regular business operations.
The Asset Test
The “asset test” – 50% or more of its assets are in investments that produce income in the form of earned interest, dividends, or capital gains.
Once an investment is classified as a PFIC, it will always be a PFIC.
In this podcast episode, we answer the question “What’s a PFIC”
Examples Of PFICs
According to the above definition, many overseas investments fall into the PFIC category. Some examples include non-US domiciled mutual funds or ETFs, private startups/family holding companies, and foreign corporations holding different assets.
In and of itself, a PFIC is a legitimate way to invest. The issue comes from how the IRS taxes them.
PFICs History Explained
In 1986, Congress enacted the PFIC regime as part of the Tax Reform Act to stop US taxpayers from deferring taxes on passive, offshore investments, such as foreign mutual funds, or from converting the income into lower-taxed capital gains.
Prior to 1986, a US tax resident could accumulate tax-deferred income from offshore/overseas investments and, upon sale of the investment, recognize gain at the long-term capital gains tax rate.
The 1986 Tax Reform Act eliminated the above.
How Are PFICs Taxed?
There are three ways your PFIC can be taxed. The taxation methods are complex, and they are best handled by a tax pro.
Excess Distribution – The Default
Under section 1291, you pay ordinary taxes on “excess distributions”. IRS defines “excess distributions” as any part of the distribution received from a section 1291 fund in the current tax year that is greater than 125% of the average distributions received.
If you sell a PFIC or receive a large distribution, the IRS considers it an excess distribution, and it also spreads the gain over the number of years you held the fund.
The back years are taxed at the highest rate possible for that year (regardless of your tax bracket), and then, for good measure, it adds an interest charge for the taxes you haven’t paid to date (the prior years). Told you it was bad!
This leads to the excessive taxation I mentioned.
Qualifying Electing Fund (QEF) Election
In this method of taxation, the PFIC is taxed similarly to a US fund. You pay taxes only on the shares of the fund that you own (as ordinary income) and net capital gain taxes every year.
For this to work, the fund has to be willing to provide extensive financial data to the IRS each year. Very few foreign funds are willing to do this.
Mark-To-Mark Election
To qualify for the MTM election, the fund must be traded on the market. Any gains are treated as ordinary income for that year. This is just a little better than the default with excess distributions, even though it treats the PFIC as if it were sold at the end of the year (fair market value).
The election needs to be made before the first year of filing and before you file taxes. If you’ve missed the prior reporting, the older reporting must be done under the default method.
This is why, when you reach out, and you’ve been holding onto your PFICs (even though you probably had no idea), we can’t just go to the MTM method right away.
The reporting, tax regime election, and the actual taxes are reported on Form 8621, which is one of the most complex forms to complete. According to the IRS, it can take up to 48 hours to complete one of these forms.
It’s why CPAs aren’t thrilled when you tell them you need to catch up on your PFIC filing.
Each PFIC fund or asset must be filed on its own Form 8621. For example, if Peter has an overseas account with 10 foreign-registered mutual funds, he’ll need to complete 10 8621 forms.
Exemption To Filing Form 8621
You may not need to file Form 8621 in the following situation, but I have seen cases where people still filed it as a precaution.
If the PFIC is in a retirement account with a pension protective wrapper, it might escape PFIC status and, hence, the need to file Form 8621.
If the PFIC value is below $25,000 (filing single), and below $50,000 (filing married), and there is no excess distribution for the year, you may be able to avoid filing the form.
Next, if you have a G-4 visa and are working in the US, you are still considered a non-resident for tax purposes. So, you are not including overseas assets in your filing, so the PFIC may not be an issue for you.
Back To The Start – PFICs Complexity
The biggest issue is not knowing you have problematic investments overseas. Very few of you know how tricky these investments are, and for most of you, it’s the first time you learn that your investment overseas is an issue and a serious one, too.
The toughest ones that I have come across are where a relative overseas passes away, and suddenly, you inherit a lot of PFICs you were not even aware of.
Unfortunately, every year you ignore the issue, it just compounds. And keep in mind that there is no statute of limitations – so if you’ve failed to file the form, waiting does not improve matters.
In addition to Form 8621, other international forms may need to be completed, such as the FBAR, FATCA, 3520-A, and Form 5471 if a foreign corporation.
Curious If Your Foreign-Domiciled Mutual Fund Or ETF Is A PFIC Or Not?. Try the following test.
What Does Your Tax Person Think?
Reach out to your tax professional, your CPA, your EA, or your cross-border professional, and ask them. If they are in the cross-border space, I’ll expect them to be able to give you an answer.
Alternatively, reach out to a cross-border financial planner, like us.
Talk To The Foreign Company/Custodian Holding Your Accounts.
Many foreign fund companies are familiar with this regime. Ask them directly whether what you have is PFIC or not.
What we’ve discovered is that if it’s a PFIC, the foreign company may not be able to provide 100% assurance. That probably gives you the answer you are looking for.
In a recent case, we reached out to the overseas company, and they responded right away, confirming that the client’s holdings were PFICs.
Examine The ISIN
Finally, look at the ISIN. The ISIN (International Securities Identification Number) is a unique identifier for all international securities. It’s a 12-character alphanumeric code that uniquely identifies a security.
If the first couple of digits are not “US”, then this is most likely a PFIC.
In this podcast episode, we answer the question “Is it a PFIC or not?”
What To Do If You Have A PFIC?
If it turns out you have PFIC, take the following steps.
Confirm it’s truly a PFIC – we’ll need the exact statements to help.
Understand whether you have missed filing the 8621 form and how far back it needs to go to make you compliant.
Act now to file the missing forms. A tax professional can help you avoid costly mistakes and penalties.
As soon as you’re caught up, establish a strategy for managing the funds going forward. For some people, selling them and taking the hit is the call, but for some, holding them and dealing with the filing may be the better option.
For example, if you are here on a temporary visa and plan to return soon, and you’ve held PFICs for a long time in a pension or other account, it may be worth a second and third conversation.
Caution – Gifting PFICs
I’ve seen cases where, as soon as somebody finds out they have PFICs, they want to sell them immediately or give them away.
Unfortunately, gifting them will trigger the same PFIC taxation issues we’ve been discussing. So it’s best to deal with them right away.
PFICs And Foreign-Born Families FAQS
Many people will have follow-up questions once they realize how the IRS treats PFICs. Below are a few.
1. Which overseas investments can you own without triggering PFIC treatment?
Yes, there are some possibilities. Some of these are individual stocks, government bonds, and a few more.
2. Are there situations where it makes sense to keep the PFIC?
Absolutely, if you are in the US on a temporary visa (such as H-1B, O-1, TN, or E-3) and plan to return to your home country soon, it may make sense to keep it. But you still want to model the situation with a cross-border CPA, to compare the numbers for keeping it, versus selling it outright. Of course, this assumes you’ve dealt with any late or missed filings.
3. At what rate are the PFICs taxed?
For the previous years, PFICs are taxed at the highest rate for that year, regardless of your individual tax rate. So you could be in the 12% tax bracket, but they get taxed at 39%.
4. I just learned about PFICs, and I think I’m delinquent. What do I do?
Take a deep breath, reach out to a cross-border CPA or EA, or reach out to us, and we can help you chart the way forward. You don’t have to deal with this on your own.
How Elgon Financial Advisors Can Help You Deal With Your PFICs And Other Planning Aspects.
PFICs can easily destroy your well-planned investment strategy. They are tax minefields that need fixing. Ignoring them is the worst thing you can do. We’d love to help you deal with them as you build generational wealth in the US.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for the purchase or sale of any security, investment advisory services, or legal advice. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Jane Mepham and all rights are reserved. Read the full disclaimer here.
