Passive Foreign Investment Company (PFIC)
Companies should carefully consider whether or not they are classified as a Passive Foreign Investment Company (PFIC). This is because being a PFIC can have unfavorable consequences to a company and its shareholders. This article will address the ways in which a company can discover if they are a PFIC and some of the consequences of being a PFIC.
What makes a company a PFIC?
There are two main ways in which a company can be classified as a PFIC: the income test and the asset test.
Income Test
The income test is met if at least 75% of the company’s gross income is considered “passive income.”
Asset Test
The asset test is met if the company’s average percentage of assets produce or have the potential to produce at least 50% in passive income. To better understand whether a company meets one of the two tests, it is important to understand what passive income is. This will be discussed in the section below
Other Considerations
Although it is generally true that companies who meet either the income or asset test are considered PFICs, there are certain exceptions to the general rules. For example, there is a start-up exception that generally allows foreign companies in the start-up phase to avoid being considered a PFIC, even if the company meets the income or asset tests.
What is passive income?
Most people understand passive income as income earned with less involvement. However, for a PFIC, passive income should be understood as income that falls under Section 954(c) of the Internal Revenue Code. Examples of this include income from rental properties, royalties, interests, dividends, and annuities. However, there are other types of passive income that a company should be aware of. Contact us today for a consultation if you would like to determine if your foreign entity is considered a PFIC.
The consequences of being a PFIC
QEF Election or Mark-to-Market Election
Having a foreign company that is considered a PFIC comes with its disadvantages if the proper steps are not taken to avoid them. Specifically, there are some major tax consequences that a US shareholder of a PFIC could face if the holder does not take the necessary steps to avoid the special rules for PFICs (i.e. making a qualified electing fund (QEF) election or a mark-to-market election).
Section 1291 Taxation / Ordinary Income Tax
If a shareholder does not make a QEF election or mark-to-market election, then the holder will be subject to taxation under Section 1291 of the Internal Revenue Code. Under Section 1291, there are two ways in which a US shareholder of a PFIC can be taxed: through distributions or dispositions.
A US holder of a PFIC that receives an excess distribution or disposition in connection with stock in the PFIC will be taxed based on ordinary income. A US shareholder of a PFIC is essentially taxed as if the holder receives income ratably over the period of time the shareholder has ownership over the stock. To be taxed ratably means to be taxed proportionally to what is gained from an investment. However, there is a formula for the ratable taxation method.