All PFICs that do not presently have Mark to Market or Qualifying Electing Fund elections are taxed under § 1291 of the Internal Revenue Code. § 1291 taxation is very complex but the basic idea is that the taxpayer will be treated as if any gain in the investment were received equally over the period of ownership and that the taxpayer was in the maximum tax bracket during each year other than the current. Eventually gain is taxed at either the taxpayer’s marginal rate for the current tax year or at the top tax rate for all earlier years which has been 35% for many years prior to 2013 when the rate rose to 39.6%, in addition interest will be added to the tax attributed to years before the current.
- 1291 taxation will always be applied on distributions/income received during the year and can be elected to clear the investment of the current unrealized gain to make way for a M2M or QEF election which would not include backward looking taxation at top rates.
To arrive at the amount of income that will be taxed as § 1291 income you must decide the amount of excess distributions each year. No gain allocated to 1986 and earlier will be PFIC income subject to taxation as an excess distribution since the regulations did not take effect until 1987. All income from the sale of a PFIC is an excess distribution. The amount by which annual income exceed 125% of the average non-excess distributions received in the past 3 years- meaning the amount that was previously included as ordinary income not subject to the high rate of taxation. Excess distributions are calculated per share so things can become unclear when there are multiple purchases.
Once the total amount of the excess distribution has been determined, you must ratably allocate the amount to each share based on the span of ownership and further to 3 different periods- each with its own set of rules:
- Prior year PFIC
- Current year
Here are some basics:
- 1291 is the default process of taxation for PFICs
- The taxpayer may choose to impose § 1291 tax on ghost income or income that has not been received yet.
- Any income or gain allocated to years before 1987 is not PFIC income
- 1291 income may be taxed as ordinary income or at the highest tax rate of a prior tax year plus interest.
- 1291 never receives reduced taxation as a capital gain
- Unrealized losses cannot offset unrealized gains
- Losses cannot be recognized until they are realized
- Gain/loss must be calculated for each share (or block of shares purchased at the same time)
- Surplus distributions must be calculated for each share (or block of shares purchased at the same time)
- Cost basis must be maintained for each share (or block of shares purchased at the same time)
There is really no way around the punitive § 1291 taxation since any direct or indirect disposition of PFIC shares including gifting, death, renouncing US citizenship and becoming a non-resident alien by moving out of the country all trigger the estimated disposition rules in § 1291. That being said- there is room for argument on these “estimated” dispositions for those who are practical enough and have the courage to challenge the interpretation of the Regs.