So what happens when a foreign person moves to the US and becomes a US taxpayer? Is a lifetime of good investing all of a sudden going to be wiped out by the PFIC rules? The good news is –absolutely not. The PFIC regulations include step-by-step transitional rules for people who are new US taxpayers.
First a quick review of a few key points:
- Non-resident aliens can’t own PFICs. The passive foreign investment company rules do not apply to anyone who is not subject to US taxation as a resident. Any unrealized gain prior to the transition to US taxpayer does not necessarily have to be subjected to section 1291 (but without good planning it could be).
- The basis of assets owned by non-resident aliens moving to the US do not automatically step-up to FMV on the day they become a US taxpayer. Don’t believe me?- give a read to Revenue Ruling 55-62 which talks about cows, but if you substitute PFIC every time the word cow is used you will see what I mean. But you can sometimes find a way- and this is one of those times!
Now that we have that out of the way- the transitional rule is pretty clear about how you need to do the math when a non-resident alien becomes a US person while owning a PFIC. There is a special rule to allow the basis to step up to the larger of adjusted basis or FMV on the date the person becomes a US resident taxpayer.
Be mindful when you have a client who has just become subject to the Internal Revenue Code as a resident taxpayer. Making a Mark to Market election in the first year will ensure that the investment will never be subjected to the nasty §1291 taxation. If the election is not made in the first year you risk making unrealized gain that otherwise would be subject to tax as ordinary income a victim of 1291 taxation at a rate of 39.6%.
The special inbound transition rule for a stepped-up basis found in §1296(l) can only be invoked if the person makes a mark to market election in the first year a person is subject to US taxation as a resident. Taxation on the prior appreciation is deferred until there is a disposition and will be taxed under §1001 at that time.
Consider the example of a Canadian taxpayer who becomes a US resident taxpayer on January 1, 2013. They enter the US with a Canadian mutual fund that they have owned since Dec 31, 2007 (5 years) and has an unrealized gain of $10,000 USD. If they make a mark to market election in 2013 (their first year in the US)they will have no income from the PFIC in 2013 (assuming there are no distributions or appreciation during 2013), and the basis for purposes of the MTM PFIC rules is the higher of the adjusted basis or FMV on January 1, 2013. When the taxpayer eventually sells the investment the $10,000 of pre-PFIC gain is taxed under IRC §1001 as long term capital gain.
If they decide to wait and not do anything and then 5 years later they sell the entire PFIC, and assuming the unrealized gain is still $10,000, the taxpayer now has to calculate the taxes under the 1291 rules and a portion of the prior appreciation is now subject to punitive taxation. Instead of -0- income and a $10,000 long term capital gain later- the taxpayer has $6000 in ordinary income ($5,000 of pre-PFIC gain taxed as ordinary income, $1,000 current year PFIC gain taxed as ordinary income and the remaining $4,000 of unrealized gain is allocated to the prior years it was a PFIC- generating $1537 in 1291 tax for the PFIC years onto which $136 interest will be added.