U.S. taxpayers who own shares in a Passive Foreign Investment Company are required to file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Election Fund. Form 8621 is an informational return detailing the value of the shares owned, any elections made, as well as any income, gains, or distributions. Form 8621 is an informational return that is filed with an individual’s 1040.
What is a Passive Foreign Investment Company?
A Passive Foreign Investment Company (PFIC) is any foreign corporation that meets the Asset test or the Income test. The Asset test is met when 50% or more of the average assets produce passive income. The Income test is met when 75% or more of the gross income is passive. A common PFIC is a foreign mutual fund.
Who Needs to file Form 8621?
Taxpayers who own shares in a PFIC need to file Form 8621 unless they meet the De Minimis exception. Taxpayers whose total PFIC value is $25,000 or less for single or married filing separately and $50,000 or less for married filing jointly do not have to file Form 8621 as long the taxpayer did not receive a distribution from the PFIC or sell any shares of the PFIC. But a taxpayer who meets the De Minimis exception will still have to file an FBAR if his foreign accounts total more than $10,000.
Part I of Form 8621
Part I of Form 8621 is the Summary of Annual Information. Here, the taxpayer must list each class of shares held in the PFIC, the date they were acquired, the number of shares held at the end of the year, and the value of the shares.
Part II of Form 8621
Part II of Form 8621 is where the taxpayer makes any necessary elections. Here, the taxpayer can elect to treat the PFIC as a Qualified Electing Fund (QEF), elect Mark-to-Market treatment, and other special elections. Electing QEF treatment allows a taxpayer to treat the fund’s long-term capital gains under preferred tax rates instead of ordinary rates. Electing Mark-to-Market allows a taxpayer to recognize an increase of fair market value of the fund into ordinary income. A taxpayer would want to do this to avoid the interest charge which is the default treatment of PFIC.
Part III of Form 8621
Part III of Form 8621 is where the taxpayer lists his pro-rata share of the Qualified Electing Fund’s income.
Part IV of Form 8621
Part IV of Form 8621 is where the taxpayer lists any gain or loss from any Mark-to-Market election. To calculate any gain or loss, the taxpayer must list the fair market value of the PFIC at the end of the year, as well as the adjusted basis of the PFIC at the end of the year. The gain or loss is figured by subtracting the adjusted basis from the fair market value.
Part V of Form 8621
Part V of Form 8621 is where the taxpayer calculates any excess distribution. If the taxpayer does not make any elections, then the default treatment of a distribution from a PFIC is to tax any excess distribution over the taxpayer’s entire holding period. An excess distribution is the portion of any distribution that exceeds 125% of the average distributions of the past three years. The portion of the excess distribution attributed to the current year is included in the current year as ordinary income, but the portion that is attributed to prior years is taxed at the highest statutory rate in effect for each of the prior years. In addition to taxes for prior years, the taxpayer must pay an interest charge as if the tax had been underpaid in the prior years.
Here’s an example of how a PFIC is taxed when there is no QEF election and no Mark-to-Market election:
Tax Year Distribution
2021 $2,000
2022 $3,000
2023 $4,000
2024 $5,000
2025 $20,000
The average distribution of tax years 2022, 2023, and 2024 is $4,000 (($3,000+$4,000+$5,000)/3). 125% of the average distribution is $5,000 ($4,000*1.25). The excess distribution for 2025 is $15,000 ($20,000-$5,000). This $15,000 excess distribution is allocated over the entire holding period. So, $3,000 ($15,000/5 years) is allocated to each of 2021-2025. The $3,000 excess distribution allocated to2025 is treated as ordinary income in 2025. The $3,000 excess distribution allocated to each of 2021-2024 is taxed at the highest statutory rate for those years, which would be 37%. So the total tax attributable to those years would be $4,440 (4 $3,000 .37).
Next the interest charge would need to be calculated. The actual rate depends on the IRS underpayment rate, which changes quarterly. The interest is compounded daily. Assuming a 7% interest rate, the amount of interest for tax year 2021 is $358. For tax year 2022 it is $259. For tax year 2023 it is $167. And for tax year 2024 it is $80. For a total interest charge of $864.
The total tax would be the sum of the tax on the $5,000 non-excess distribution, tax on the current-year excess allocation, the tax on the prior-year excess allocation, and the interest charge. Assuming a 24% current year marginal tax rate:
$5,000 non-excess distribution $1,200
$3,000 current-year allocation $720
$12,000 prior-year allocation $4,440
Interest Charge $864
TOTAL $7,224
Part VI of Form 8621
Part VI of Form 8621 is where the taxpayer keeps track any Section 1294 election made in prior years. A Section 1294 election is made to defer paying the tax on a taxpayer’s pro-rata share of a QEF’s undistributed income. Without the election the taxpayer would have to pay the tax on his pro-rata share of income but would not have the cash to do so until the income was distributed. Making a 1294 election extends the time the taxpayer has to pay the tax, but the IRS treats this extension as a loan, so the taxpayer needs to pay interest on this loan. Part VI of Form 8621 keeps track of the tax payment that was deferred as well as interest on the tax payment.
Penalties for not filing Form 8621
Unlike FBAR, FACTA, and Form 5471, there is no direct financial penalty for failing to file Form 8621. But if Form 8621 was not filed for a particular year, the statute of limitations for the year remains open indefinitely, so the IRS can audit that entire tax year (not just Form 8621) until Form 8621 is filed. If the taxpayer had an excess distribution or gain from a PFIC that wasn't reported, the punitive default Section 1291 tax regime applies.
Form 8621 is one of the most complicated tax forms to file. Not only are there six parts to the form, with different calculations for Mark-to-Market, Pro-rata income, and excess distributions, but a new form must be filed for each individual fund a taxpayer owes rather than one per broker account. Given the complexities surrounding Form 8621, it is imperative to review your reporting obligations with a tax professional annually.
At Safeguard Law, PLLC, our team of experienced tax attorneys specializes in helping our clients navigate issues such as this. Contact us today to schedule a consultation! Our main business line is (202) 505-1741.