The term “passive foreign investment company” (PFIC) suggests a sophisticated, highly specialized investment that the majority of U.S. persons probably would not own. In reality, many U.S. persons–whether living in the United States or abroad–may unwittingly become PFIC shareholders and thus subject to unexpected federal income tax and reporting requirements.
PFICs are foreign corporations that generate 75% or more of their gross income from passive sources or that own assets that are primarily held for the production of passive income (i.e., more than 50% of the entity’s asset value is represented by assets that generate passive income). Common examples of PFICs are foreign-based mutual funds and start-up companies that unexpectedly fall within the scope of the PFIC trap, as well as foreign corporations that hold real estate investments. Foreign mutual funds typically are considered PFICs because they are foreign corporations that generate more than 75% of their income from passive sources such as capital gains and dividends. Certain start-up companies are also at risk of being subject to the PFIC rules because they typically have loss-making operations in their beginning years and may have small sources of passive income such as interest income from bank accounts.
So, what is the consequence of a foreign corporation being a PFIC? By default, any future distributions from that PFIC (or sale of the PFIC interest by the shareholder) are taxed at a punitive tax rate that also includes an interest charge going back to the date that the taxpayer acquired the PFIC. While there is a way to avoid this result, it requires a tax election be made in the first year of the PFIC status, which is not always possible.
Furthermore, the IRS requires that taxpayers disclose PFIC investments on their individual income tax returns. Failure to do so carries the consequence that the normal three-year statute of limitations for the IRS to assess tax may never begin running because the tax return is deemed incomplete.
If you believe that you own a PFIC, please contact us to discuss how to become compliant with the PFIC reporting and best minimize the adverse tax consequences.