PFIC Compliance on Expatriate Taxes

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While most US expats are now aware of the Foreign Account Tax Compliance Act (FATCA), which is designed to track US expats with accounts in foreign banks and institutions, many expats may not be as familiar with the IRS’s enforcement of Passive Foreign Investment Corporations (PFIC) regulations. Because the definitions are somewhat vague, many US expats may not know that they must comply with PFIC rules, which in turn, could result in severe penalties. Here’s what you need to about about a PFIC’s impact on your expatriate taxes.

Who should be aware of PFICs?

According to the IRS, PFIC regulations apply to anyone who is “a direct or indirect shareholder of a passive foreign investment company (PFIC).” Foreign corporations are designated as a PFIC if they meet the two criteria outlined below:

  1. Income test – 75% or more of the corporation’s gross income for its taxable year is passive income
  2. Asset test – At least 50% of the average percentage of assets held by the foreign corporation during the taxable year are assets that produce passive income or that are held for the production of passive income.

This definition essentially describes money market funds, hedge funds, private equity funds and similar types of foreign investments.

Tax Rates for PFICs

For individuals with investments in PFICs, the tax rates may come as quite a shock. Tax rates are based on the following:

  • Distributed income – taxed as ordinary income at the highest federal tax rate
  • Capital gains – taxed as ordinary income at the highest tax rate
  • Deferred gains – non-deductible penalty interest charge that is compounded

Individuals may be able to avoid such high tax rates if they file through the mark-to-market method. This means that all gains earned – whether distributed or not – will be taxed at the investor’s marginal tax rate. However, this requires taxpayers to complete Form 8621 each year, which can be a hassle.

PFIC Concerns for US Expats

One of the biggest concerns regarding PFICs is that neither US expats for offshore funds are aware of the different regulations for these types of investments. Many US expats report foreign investments similar to domestic funds without realizing there are different reporting requirements.

In addition, US-based tax accountants who are unfamiliar with US expat taxes may be hesitant to discuss PFICs because of the complicated process and lengthy paperwork.

US Expats: Need Help with Filing US Expatriate Taxes?

For additional information on PFICs, check out this information from Creveling & Creveling.

US expats can learn a great deal about their filing requirements and available deductions in our “US Expat Taxes Explained” series. If you have questions about your US taxes, or if you would like help completing your US expat tax return, please contact us.