Table of Contents
- What Is a Passive Foreign Investment Company (PFIC)?
- How a Passive Foreign Investment Company (PFIC) Works
- Fast Fact
- PFICs and Tax Strategies
- Important
- PFICs and the Tax Cuts and Jobs Act
- What Is Considered a PFIC for U.S. Tax Purposes?
- Is PFIC Income Taxable?
- How Can I Avoid PFIC Status?
- What Are Examples of Passive Income?
- The Bottom Line
What Is a Passive Foreign Investment Company (PFIC)?
Let me explain what a passive foreign investment company, or PFIC, really is. It's a corporation based outside the U.S. that meets one of two key conditions based on its income or assets. For the income test, at least 75% of its gross income has to come from passive sources, like investments, not from regular business operations. Or, for the asset test, at least 50% of its assets must be the kind that generate income through interest, dividends, or capital gains.
Key Takeaways
- A foreign corporation qualifies as a PFIC if 75% or more of its gross income comes from non-business activities.
- It also counts as a PFIC if at least 50% of its average assets are held to produce passive income.
- PFICs face strict and complex tax rules from the IRS.
- If you're a U.S. investor with PFIC shares, you need to file IRS Form 8621.
- These rules help close tax loopholes that let some U.S. people avoid taxes on foreign income.
How a Passive Foreign Investment Company (PFIC) Works
PFICs came into focus with the tax reforms of 1986. These changes aimed to shut down a loophole where U.S. taxpayers hid offshore investments from taxes. Not only did they bring these investments under U.S. taxation, but they also hit them with high tax rates to deter the practice.
You'll often see PFICs in things like foreign mutual funds or startups that fit the definition. For instance, a foreign mutual fund is typically a PFIC if it's a foreign corporation getting over 75% of its income from passive sources such as capital gains and dividends.
Investments labeled as PFICs follow strict tax guidelines from the IRS, detailed in Sections 1291 through 1298 of the U.S. tax code. Both the PFIC and its shareholders must keep precise records of transactions, including share cost basis, dividends, and any undistributed income.
Take the cost basis rules as an example of how tough these taxes can be. Normally, if you inherit shares of most securities, you can step up the cost basis to the fair market value at inheritance. But for PFIC shares, that's usually not allowed.
Fast Fact
Figuring out the right cost basis for PFIC shares is often a tough and confusing task.
PFICs and Tax Strategies
If you're a U.S. investor holding PFIC shares, you have to file Form 8621 with the IRS. This form reports distributions, gains, income, and any QEF election increases. It's a long, complicated form—the IRS says it can take about 49 hours to complete—so I recommend getting a tax professional to handle it.
You won't face specific penalties if there's no income to report, but not filing can make your entire tax return incomplete.
There are ways to lower the tax rate on PFIC shares, like getting the investment recognized as a qualified electing fund (QEF). But watch out—that can create other tax issues for you as a shareholder.
Important
If you acquired PFIC shares before 1997, you're not subject to the tax and interest rules for those shares.
PFICs and the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act of 2017 changed PFIC rules, including an exception for the insurance industry. Now, income from a foreign corporation's insurance business isn't passive if it's after December 31, 2017, unless the insurance liabilities are more than 25% of total assets on the financial statement.
In December 2018, the IRS and Treasury proposed updates to PFIC taxes, easing some FATCA rules and better defining investment entities. These took effect on January 14, 2021.
What Is Considered a PFIC for U.S. Tax Purposes?
The IRS says a PFIC is a non-U.S. entity that passes the income test (75% or more gross income from non-business activities) or the asset test (at least 50% of assets for passive income).
Is PFIC Income Taxable?
Yes, gains and distributions from a PFIC count as ordinary income, and you report them on IRS Form 8621.
How Can I Avoid PFIC Status?
To diversify globally without PFIC issues, consider U.S.-based mutual funds or ETFs that invest in foreign assets, like those focused on emerging markets stocks or global debt.
What Are Examples of Passive Income?
The IRS defines passive income as earnings from rentals, limited partnerships, or businesses where you're not actively involved, including rents, royalties, interest, dividends, and capital gains.
The Bottom Line
Before the mid-1980s, U.S. investors could dodge taxes by putting money in foreign entities generating passive income. That loophole is closed now, and if you hold such assets, you must report them as PFICs, with the income taxed as ordinary. A foreign firm qualifies if 75% of its gross income is passive or more than half its assets generate passive income.
