(or "fair when you thought you were salubrious because your foreign corporation isn't a CFC...")
Background - There seems (understandably) to be a delicate amount of confusion on how to treat PFICs, whether directly owned by US taxpayers or by entities (e.g., partnerships) in which they have an ownership interest. The purpose of this QA is to explain some of the questions and provide guidance for further research if needed. This is not meant to be an exhaustive discussion of the PFIC rules, but simply a starting point. If you have further questions, please ask!
1. What is a PFIC and why is that classification relevant?
A PFIC (short for "Passive Foreign Investment Company") is a foreign corporation that meets either an asset test (at least 50% of the foreign corporation's assets either actually glean, or are held to obtain, passive income) or an income test (at least 75% of the foreign corporation's corrupt income is passive income) . PFICs are subject to special rules meant to limit a US taxpayer's benefit from deferring income earned by the PFIC (e.g., fragment 1291, which imposes an interest charge on "excess distributions") .
Passive income in this context is any income treated as "foreign personal holding company income" under fragment 954(c) . This generally (but with exceptions) includes dividends, interest, royalties, rents, annuities, score gains on property that give rise to the aforementioned items, certain catch commodity transaction gains, sure bag foreign currency gains, income equivalent to interest and dividends, obvious gain derivative gains, and positive personal service contracts that can be fulfilled by others.
While there are a number of exceptions to these general rules, they are beyond the scope of this QA. For further information, please inaugurate with sections 1291 through 1298.
2. What is a QEF and why is it relevant?
A QEF (short for "noble Electing Fund") is a PFIC for which the US shareholders (whether content or indirect) have elected under portion 1295 to gape their proportionate piece of the PFIC's unusual earnings and profits (as ordinary earnings and pick up long-term capital buy up, as the case may be) . Please glance below for further information.
In addition, a QEF election (if made for the year in which the electing US shareholder first held the PFIC's stock) will generally prevent the application of the otherwise-required anti-deferral rules (e.g., part 1291) .
3. How is a PFIC's US shareholder taxed if the PFIC does not have a QEF election in station?
If no QEF election was made, the US shareholder will generally be taxed as follows:
* Income/gains earned by the PFIC - No impact.
* Deductions/losses incurred by the PFIC - No impact.
* Distributions by the PFIC: Distributions by the PFIC will be treated as dividends to the extent of the US shareholder's allotment of the PFIC's EP (short for "Earnings Profits"), with any excess applied first against stock basis (until zero) and then to capital collect. In addition, "excess distributions" are subjected to the interest charge rules of fraction 1291 (as well as a historical lookback/grossup re the taxes that would have been paid, using the highest applicable ordinary income rates for those years) . This requires the US shareholder to track taxable distributions for the preceding 3 years and if the new year distributions exceed 125% of that 3-year average, the excess is considered an "excess distribution."
Note: If the US shareholder held the stock for less than 3 years, they spend the average for that shorter preceding period. In addition, there can be no excess distributions in the 1st year in which the US shareholder held the PFIC's stock.
Note: All distributions "in respect of stock" of the PFIC are included for purposes of determining excess distributions, even if those amounts would otherwise have been nontaxable to the US shareholder (e.g., distributions in excess of the PFIC's EP which would otherwise have been treated as returns of capital) .
* salvage on disposition of the PFIC stock by the US shareholder - Treated as an excess distribution in its entirety, which includes taxation at ordinary income rates.
* Loss on disposition of the PFIC stock by the US shareholder - Treated as a capital loss.
4. How is a PFIC's US shareholder taxed if the PFIC has a QEF election in spot?
If a QEF election was made, the US shareholder will generally be taxed as follows (but examine also the comment below regarding situations in which the US shareholder doesn't find the QEF election with respect to a particular PFIC in the 1st year of stockholding) :
* Income/gains earned by the PFIC - Included in income and an increase to basis in PFIC stock. If ordinary income, the US shareholder's pro rata portion of the ordinary earnings of the QEF for such year. If long-term capital glean, the US shareholder's pro rata fragment of the gain capital net of the QEF for such year.
* Deductions/losses incurred by the PFIC - No impact.
* Distributions by the PFIC: (1) Distributions of previously recognized/taxed income - Excluded from income, but reduces basis in PFIC stock. (2) Distributions of current-year recognized/taxed income - Excluded from income, but reduces basis in PFIC stock. (3) Distributions in excess of cumulatively recognized/taxed income - Reduces basis in PFIC stock as a return of capital; amounts in excess of basis are capital gains.
* procure on disposition of the PFIC stock by the US shareholder - Treated as a capital pick up (long or short as the facts dictate) .
* Loss on disposition of the PFIC stock by the US shareholder - Treated as a capital loss.
5. What if the PFIC is also a CFC (a "Controlled Foreign Corporation")?
A CFC is defined under part 957(a) and is a foreign corporation controlled (more than 50%) by US shareholders that each have at least 10% of the foreign corporation.
If a PFIC is also a CFC, portion 1297(d) (1) generally treats the foreign corporation as not being a PFIC during the "sterling fragment" of such shareholder's holding period with respect to stock in that corporation. The "handsome portion" means the portion of the shareholder's holding period which is after 12/31/97, and during which the shareholder is a "United States shareholder" (i.e., owns at least 10% of the foreign corporation) and the foreign corporation is a CFC.
Caveat: impartial because a CFC isn't generally subject to the PFIC rules doesn't mean there aren't issues to deal with. There are, but they are beyond the scope of this QA.
6. Who makes the QEF election, and when/how is it made?
The QEF election may only be made by the first US person (including a domestic partnership, S corporation, or estate) that is a yell or indirect shareholder of the PFIC. For example, if a US individual ("USI") is a partner in a US partnership ("USP"), which is a partner in a foreign partnership ("FP"), which is a shareholder in a PFIC, the QEF election could only be made by the US partnership ("USP") .
A US shareholder generally must finish a QEF election by the due date (including extensions) for filing the US shareholder's federal income tax return for the first year to which the election is desired to apply. The election will then apply to that (and all subsequent) years of that foreign corporation. The election is made by completing the applicable parts of execute 8621 and attaching it to the US shareholder's timely-filed federal income tax return.
7. Is the QEF election required to be made in the first year the US shareholder owns the PFIC stock?
No. However, if the US shareholder does not get the election in the 1st year of holding the stock, it will be subject to both the fragment 1291 rules and the QEF rules.
8. If the US shareholder doesn't do the QEF election with respect to a particular PFIC in the 1st year of stockholding, how can they avoid the allotment 1291 rules?
There are several ways to do so, including (but not microscopic to) the following:
* Deemed sale election - The US shareholder may prospectively treat the PFIC as if it had been a QEF from the 1st year in which they held stock (i.e., a "pedigreed PFIC") by electing under fraction 1291(d) (2) (A) to inspect fetch on the sale of that PFIC's stock on the first day of the year for its glowing market value (with the regain, if any, treated as an excess distribution for part 1291 purposes) . Caveat: The US shareholder must meet 3 tests to qualify for this election: (1) The PFIC becomes a QEF with respect to the US shareholder for a taxable year which begins after December 31, 1986, (2) The US shareholder holds stock in that PFIC on the first day of such taxable year, and (3) The US shareholder establishes to the IRS's satisfaction the elegant market value of such stock on such first day.
* Deemed dividend election - The US shareholder may prospectively treat the PFIC as if it had been a QEF from the 1st year in which they held stock (i.e., a "pedigreed PFIC") by electing under share 1291(d) (2) (B) to include in cross income as a dividend an amount equal to the section of the post-1986 earnings and profits of such company attributable to the stock in the PFIC. This amount will be treated as an excess distribution. Note/Caveat: The US shareholder must meet 3 tests to qualify for this election, but this election is generally relevant to less-than-10% US shareholders due to the elimination of the CFC/PFIC overlap (as well-known above) in 1997: (1) The PFIC becomes a QEF with respect to the US shareholder for a taxable year which begins after December 31, 1986, (2) The US shareholder holds stock in that PFIC on the first day of such taxable year, and (3) The PFIC is a CFC.
* Retroactive election - The US shareholder may retroactively treat the PFIC as if it had been a QEF from the 1st year in which they held stock (i.e., a "pedigreed PFIC") by electing under Treas. Reg. section 1.1295-3(b) if they: (1) Reasonably believed that as of the election due date the foreign corporation was not a PFIC for its taxable year that ended during the retroactive election year, (2) Filed a Protective Statement with respect to the PFIC, applicable to the retroactive election year, in which the shareholder described the basis for their reasonable idea and extended the periods of limitations on the assessment of PFIC-related taxes for all taxable years of the shareholder to which the Protective Statement applies, and (3) Complied with any other terms and conditions of the Protective Statement.
9. Do dividends from a PFIC qualify for the federal 15% capital gains tax rate (whether or not a QEF election has been made)?
No. share 1(h) (11) (C) (iii) specifically excludes dividends from a PFIC from the special noble rate.
10. Does California conform to these rules?
No. As a result, you will often gawk differences in both income recognized (as well as differences in stock basis) between federal and California. California taxes distributions from a PFIC when made to the US shareholder.
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