Passive Foreign Investment Companies (PFICs) are non-U.S. entities that generate at least 75% of their gross income from non-business activities. PFICs are generally non-U.S. mutual funds, ETFs, and other similar types of income-generating foreign investments. These non-business activities in these entities generate a passive income that could include:
- Capital gains from the disposition of securities
Why PFICs are terrible for most U.S. expats?
PFICs complicate the tax return process. If you own a PFIC, you have to do all kinds of special calculations and add special forms during your tax return. Even more, they may end up causing higher taxes than other types of investment income.
First, you have to figure out whether you have a PFIC. Then, you have to figure out whether you have to file Form 8621. You also have to figure out complicated calculations for the numbers that flow onto the form and calculate what rate of tax should apply. This is often the higher marginal rate of tax rather than the lower 15% or 20% qualified dividend and long-term capital gain rates. Needless to say, this can be challenging for someone who is not an accountant.
You’ve got to figure out how to do everything correctly to avoid making mistakes on Form 8621. If you don’t file the form, or mistakenly report your income correctly, there can be a fine of up to $10,000.
Generally, the IRS taxes PFICs under one of three different methods:
- The excess distribution method
- The qualified electing fund method
- The mark-to-market method
The last two methods require special elections at the right time. This means they often don’t apply to many taxpayers. We often use the excess distribution method as the default for calculating the income to report from a PFIC on Form 8621.
There is a complicated set of factors to consider when you own a PFIC. You need to look at what distributions the PFIC made in the current tax year. Then, you must determine whether that level of distribution is higher than 125% of the average of the distributions in the three preceding years. And if so, you need to report it following a specific process. Not only do you calculate the income subject to tax at the higher marginal rates, but you also pay an interesting element that significantly increases the overall cost.
I want to know more about US taxes abroad
Why PFICs are not taxed as long-term capital gains
The rules for taxing PFICs are entirely based on the U.S. government rules and instructions from the U.S. Internal Revenue Service (IRS). If you have a U.S. investment, you can get qualified dividends and long-term capital gains tax at the lower 15% and 20% rates. But these rates only apply to a U.S.-based fund.
Those funds are already subject to all sorts of reporting requirements. The taxpayer and the IRS get a Form 1099 at the end of the year. This form clearly explains all the different income streams of the taxpayer, what category they fall into, and therefore, what tax rate will apply. If the fund is located outside the U.S., the IRS doesn’t get any of that documentation.
With a PFIC, the IRS does not know the nature of the income streams coming from these funds. And so, they don’t know the nature of the stream or the nature of the tax rate that should apply. As a result, they take a default position of assuming that all of it should be taxed at a higher level.
All these factors make it much more expensive for U.S. taxpayers to own this kind of entity. It’s generally better for most U.S. expats to consider structuring their investments within the U.S. to avoid all the extra reporting requirements and costs that come with owning PFICs.
We provide tailored tax services for U.S. expats across different regions across the world. You can book a consultation with our team using our contact form right here for world-class service. You can also call us or send an email. Our team of highly experienced and region-specific expatriate accountants will be happy to help you!