Living abroad and considering foreign investment funds? Take a good look at potential liabilities before you invest.
A passive foreign investment company (PFIC) is a corporation registered outside of the U.S. that offers pooled investments. These investments might be money market funds, rents, hedge funds, or foreign mutual funds, among others. An investment company is considered a PFIC through an income and asset test. A PFIC generates 75 percent or more of its gross income from non-business activities or at least 50 percent of its assets generate passive income. Foreign companies with ongoing business activities are not considered PFICs and are not subject to the regulatory deterrence reserved for PFICs.
If you are a foreign executive or a U.S. green card holder living in a foreign country, you remain obligated to file an annual tax return in the U.S. While a PFIC may sound like a deal—it is a good idea to understand PFICs before you buy in.
PFICs have been around for decades. Created by the Tax Reform Act of 1986, PFICs are intended as an antidote to tax fraud and are aimed at U.S. taxpayers investing in foreign corporations that heavily generate passive income. The rules around PFICs were modified by the 2017 Tax Cuts and Jobs Act (TCJA). Upfront points to know about a PFIC include:
- Remember that PFIC status is conferred on a company to prevent tax evasion using offshore companies and foreign bank accounts. If you receive direct or indirect distributions from a PFIC, these are considered ordinary income and must be reported to the IRS on Form 8621.
- Regulations around PFICs are complex and lack of understanding can lead to IRS penalties and interest as well as high tax rates. There are three methods by which PFICs can be taxed. These are excess distribution, mark-to-market elections (MTM), and qualifying electing funds (QEF).
- Prior to the tightening of the regulatory environment, U.S. investors could avoid paying some taxes by putting their money into foreign companies that generate primarily passive income. As loopholes closed, rules around PFICs became less profitable and subject to higher taxes.
The U.S. along with other countries is working to enact and enforce rules to discourage opaque investments in foreign interest. If you are interested in a PFIC investment, talk to a tax attorney with experience in the potentially punishing measures of the PFIC tax regime.
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Robert J. Fedor, Esq., LLC offers strategic legal guidance to clients throughout the U.S. and abroad on IRS audits, criminal tax investigations, and employment tax disputes. When you have questions about individual or business tax compliance, call us at 800-579-0997 or contact us. We have offices in Cleveland and Chicago.