It's good to know what a passive foreign investment company (PFIC) is, because if you're invested in one, you may be required to file certain tax forms, follow certain tax rules, and probably pay more in tax than you expected to.
What a PFIC is and why it matters
First, let's clarify what "passive income" means. Passive income is money that comes to you with little effort of your own -- examples include interest, dividends, royalties, rent, or certain capital gains. Active income comes from work you performed.
You've got a passive foreign investment company on your hands if it's a non-American company and one of the following conditions apply:
- 75% or more of its gross income is passive, or
- 50% or more of its assets produce passive income
Many pooled investments such as mutual funds and partnerships qualify as PFICs.
Passive foreign investment companies came into existence via 1986 tax reforms. They were meant to close a loophole that U.S. taxpayers were using to maintain investments off-shore, sheltering them from U.S. taxation.
Why should you care about PFICs? You should care because they will probably cost you more in taxes. For example, most dividends paid to U.S. shareholders from U.S.-based mutual funds get a 15% tax haircut. Not so with PFICs. Their dividends, interest payments, and unrealized capital gains generally get whacked with the taxpayer's ordinary income tax rate, which can exceed 30%.
Meanwhile, if you inherit shares of a non-PFIC investment, you typically get to "step-up" the cost basis to their fair market value at the time of inheritance (i.e., the day Uncle Bertram passed away). But you don't automatically get to step up PFIC cost bases upon inheritance, and in fact, determining PFIC cost bases can be complicated, with professional help advised.
All of this matters to investors -- especially non-U.S. citizens who move to the United States. That's because if you move to America from, say, Spain, your portfolio probably holds Spanish mutual funds and other PFICs, causing you to run into the tricky and often costly PFIC rules.
What to do
If you have any PFIC investments, you should be sure to keep records related to them, including cost bases, dividends received, and undistributed income. You, or whoever prepares your taxes, will need to refer to them in the future.
You might not want to tackle your taxes on your own if you have any dealings with PFICs, though, and you might not want to hire a tax preparer who principally deals with ordinary tax returns, either. You're also likely to find that any tax-preparation software you're using won't deal with PFICs.
An experienced, well-trained tax pro such as an accountant or Enrolled Agent (a federally authorized tax pro who has either passed some rigorous exams or worked at the IRS) is likely to serve you best, because of the complications of the regulations and IRS Form 8621, which runs three pages, asks for a lot of information, requires a variety of calculations, and offers eight elections you can make regarding your PFIC investments.
Form 8621 has a long name: Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. Its instructions are long, too, taking up 13 pages, and glancing through them will likely have you looking for a tax pro. The IRS offers these estimates of how long it will take some taxpayers to deal with Form 8621:
- Recordkeeping: 16 hr., 44 min.
- Learning about the law or the form: 9 hr., 56 min.
- Preparing and sending the form to the IRS: 14 hr., 14 min.
A savvy tax pro who is familiar with foreign passive income companies will save you a lot of time -- and very possibly a lot of money, too.