patrickbland, jd, mba, llm

PFIC Code Outline:

• Subpart A—Interest on Tax Deferral

1. §1291 Interest on Tax Deferral

• Proposed Regs:
  • §1.1291-1 – Taxation of U.S. Persons that are Shareholders of §1291 Funds
  • §1.1291-2 – Taxation of DISTRIBUTIONS by §1291 Funds
  • §1.1291-3 – Dispositions of §1291 Funds
  • §1.1291-4 – Deferred Tax Amount (relating to §1291(c))
  • §1.1291-5 – Coordination with the FTC Rules
  • §1.1291-6 – Nonrecognition Transfers of Stock of §1291 Funds
  • §1.1291-9 – Deemed Dividend Election
  • §1.1291-10 – Deemed Sale Election
  • Subpart B—Treatment of Qualified Electing Funds

1. §1293 Current Taxation of Income from Qualified Electing Funds
2. §1294 Election to Extend Time for Payment of Tax on Undistributed Earnings
3. §1295 “Qualified Electing Fund”

• Subpart C—Election of Mark to Market for Marketable Stock

1. §1296 Election of Mark to Market for Marketable Stock

• Subpart D—General Provisions

1. §1297 Passive Foreign Investment Company (“PFIC”) Defined
2. §1298 Special Rules

Class Notes:

• What kind of entity is a PFIC? A Foreign Corporation…. Needs to be a foreign corporation… doesn’t use term in title, it is a prerequisite that the entity be a foreign corporation before it’s a PFIC
• PFIC Tests—

1. Income—

• If publicly traded company – (e)(1) forces it to use the value test

1. Asset—
2. Need to know what income the FC is generating… we’re trying to segregate the income into 2 categories: 1) passive; 2) not passive

• §954(c) – incorporates foreign personal holding company income… 4 exceptions in 1297(b)(2)
• Foreign Personal Holding Income is our starting point… passive income if FPHI w/in meaning of 954(c) subject to a few exceptions

1. MUST BE FOREIGN PERSONAL HOLDING INCOME TO BE “PASSIVE INCOME” FOR PURPOSES OF PFIC!!
2. Is it an active asset or passive asset? à look to the income generated by the asset and categorize that under the 954(c) rule… if the asset produces a 954(c) income, then the asset is a passive asset… if the assn’t doesn’t produce this kind of income, it’s not a passive asset

• Change of Facts—what if TA is an investment advisory service and all income is from fees charging clients for their services? So, in a given year, it earns 100 of fees, and earns 10 of interest income. Is it a PFIC or NOT a PFIC?

1. Not a PFIC, because looks at 954(c) to determine if income is passive… the $100 is services income…. the $10 of interest might be passive… then look to see if it meets the asset test…
2. What are the assets of a services company? Trying to illustrate here… when people think of PFICs, thinking of foreign mutual funds, investment funds, that’s what they were targeted at… what are the assets? Some desks, chairs, computers, telephones, goodwill, maybe some investments – would be passive assets…

• If a CFC, how do we measure the goodwill? Have to use the adjusted basis… so unless it’s purchased the goodwill, that goodwill has no value… self created goodwill has no adjusted basis…
• It’s balance sheet will be b/c it doesn’t have many tangible assets, would have more passive assets than nonpassive assets… so very easy for an active business to become a PFIC
• NOTE: BECAUSE AN ACTIVE BUSINESS DO NOT ASSUME IT’S NOT A PFIC!
• IF NOT A CFC AND NOT PUBLICLY TRADED à have choice of using FMV… if CFC don’t have that choice

1. What if clients don’t pay fast, and they accumulate lots of receivables—

• $30 of tangible active business assets
• Accounts receivable ---
  • Impact of A/R

1. When to apply value of assets for asset test?

• Taxable year – look at taxable year of corporation
• It says use the “average” percentage of assets held by corporation during taxable eyar
  • Take it on daily basis and do weight average? Test it once?
  • No regs on this – the IRS did issue a notice back in 1988… Notice 88-22 and it said that regs will provide, when they’re issued that will do it on a quarterly basis.. will look at balance sheet on quarterly end…
  • Payment of service receivable would probably be active and not passive…
  • Cash and working capital – passive b/c it produces interest income or no income at all… either of which under 954(c) would be passive

1. Don’t collect receivables! Leave them outstanding at quarter end! Most likely to be active…

• Change of Facts—TA has a wholly owned subsidiary w/ one million in assets… all involving manufacturing of widgets…

1. §1297(c) applies….

• In testing the PFIC, if it owns 25% or more of lower tier corporation, attribute a prorata amount of lower tier corps…
• ONLY LOOKING DOWN! Not looking up
• TA NOT a PFIC
• Change of Facts—TA has wholly owned subsidiary w/ one million in cash sitting in the bank

1. Sub has 1m of assets… 25% look thru rule only goes one way… only attributes from lower tier entity to upper tier entity to TEST THE UPPER TIER ENTITY! It doesn’t test the lower tier entity

• If no election by SH – inclusion in gain due to excess distribution or disposition of PFIC stock…

1. Default rules of 1291 – only trigger tax consequence WHEN SOMETHING HAPPENS TO THE SHAREHOLDER… SH has some kind of income event… some kind of distribution from PFIC or disposes of shares at a gain
2. NEED SOME KIND OF TRIGGERING EVENT TO THE SH FOR PFIC INCLUSION

• Definition of Net Capital Gain? à §1222(11)
• If Pedigree QEF—

1. Ordinary earnings and capital gain flow through to the shareholder
2. Consequence – USP of TA being a PFIC – because the CFC rules apply due to the overlap rule
3. Up until the PFIC rules in tax reform of 1986, before that time we didn’ thave PFIC… from 86 to 1997, a corporation which was a PFIC and a CFC produced CFC tax consequences to its SHs AND PFIC consequences to its US Shareholders… there was somewhat of an overlap rule, but not a complete one… then along comes 1997 act, and says if FC wasn’t a PFIC prior to the end of 97, then US SH that held shares of stock at before 12/31/97, don’t have to worry about PFIC rules

• If US SH, and it was a CFC before 1/1/98 and ALSO a PFIC, election to treat stock at 12/31/97, cleaning it up, eliminating the PFIC taint…

1. OVERLAP RULE – GETTING A LOT OF ATTENTION FROM THE IRS AND CONGRESS!! BE PREPARED FOR THIS!

• Unpedigree QEF—

1. If QEF election is made, TP picks up each year, it’s share of ht eincome of that PFIC, and that income falls into 1 of 2 characters – ordinary earnings or net capital gain… that’s the reason people make the QEF election… another reason is to avoid application of §1291…

• FATCA – bill shoehorned into HIRE, and contains a whole set of provisions that overrides the holding and exemptions from withholding… affecting for the most part US persons hiding assets overseas… one of the provisions is increasing the reporting obligations for US persons who own interests in PFICs… IRS Notice says that this new provision will not apply until reporting in 2011 and therefore doesn’t apply to interests held now

PFICs

• Generally—

1. Objective: to deprive a US TP of the economic benefit of deferral of US tax on the TP’s share of the undistributed income of a foreign investment company that has predominantly passive income, however small the individual or aggregate interests of the U.S. persons in the company may be.

• Necessary to eliminate the advantage previously enjoyed by US SHs in foreign investment funds not controlled by US persons, who were not taxed on current income of the fund, over US SHs investing in domestic investment funds who were.

1. PFIC Rules MAY APPLY to any US person holding stock in any foreign corporation, even one engaged in an active foreign business such as manufacturing, for any tax year in which the corporation derives enough passive income or owns enough passive assets to meet the definition of a PFIC.
2. PFIC Rules DO NOT APPLY to a US person owning stock in a foreign corporation during periods after 1997 when the US person meets the definition of “US Shareholder” in §951(b) and the corporation meets the definition of a CFC in §957(a).
   
   

• 3 Sets of Rules for Ending or Recapturing the Benefits of Deferring U.S. Income Tax on Foreign Earnings of PFICs:

1. 1) Current Inclusion under Qualified Electing Fund Election §1293—

• Only applies to PFICs that are “Qualified Electing Funds” under §1295
• Rule: The electing U.S. persons holding stock in the PFIC include currently in gross income their pro rata shares of the PFIC’s earnings. These U.S. persons may elect to defer payment of the tax, subject to an interest charge, on the portion of the PFIC’s earnings not currently included.
• Coordination of §1291 Rules w/ Qualified Electing Fund Rules—

1. 2) Current Taxation under Mark-to-Market Election §1296—

• Only available if the stock of the PFIC is “Marketable Stock”
• Rule: a U.S. person owning stock in the PFIC may elect to mark to market the value of the PFIC’s stock each year. If the election is made, the U.S. person includes in gross income the excess of the FMV of the PFIC’s stock at the end of the year over the U.S. person’s adjusted basis of the stock.
  • IF FMV of PFIC Stock > Adjusted Basis @ end of the year à U.S. person allowed to deduct such excess (subject to a limitation)
  • Coordination of §1291 Rules w/ Mark-to-Market Exception—

1. 3) Deferral of Tax, but with an Interest Charge until Sale of PFIC Stock or “Excess Distribution” is received

• Applies to PFICs that are NOT Qualified Electing Funds and for which the US person owning stock can’t make the mark-to-market election OR has not made such an election
• Rule: the US persons holding stock in the PFIC pay tax when they receive the distribution from the PFIC or sell their shares of PFIC stock, but also must pay an interest charge attributable to the value of the tax deferral when they receive an unusually large distribution (called an “excess distribution”) or have gain from the disposition of the PFIC stock.
• “Excess Distribution”—§1291(b).
  
  
• Definition of PFIC – §1297

1. General Rule—1297(a)—PFIC means any foreign corporation if:

• 1) Income Test—75% or more of the gross income of the corporation for the taxable year is “passive income” OR
• 2) Asset Test—the average percentage of its assets producing passive income or held for the production of passive income is at least 50%
  • If satisfy either test à then foreign corporation is a PFIC
  • *** Special Rules Applicable to Income and/or Asset Tests ***
    • §1297(c) Look-Through for 25%+ Owned Subsidiary à if a FC owns, directly or indirectly, at least 25% (by value) of the stock of another corporation, whether U.S. or foreign, the FC is treated as owning its proportionate share of the other corporation’s assets and as receiving directly its proportionate share of the other corporation’s income in determining whether the foreign corporation is PFIC.

1. Applies for purposes of both the income test and asset test of upper tier owning corporation
2. Impact on Income Test—amounts such as dividends and interest received from 25% or more owned subsidiary are ELIMINATED from the FC’s income for purposes of the income test
3. Impact on Asset Test—The FC’s stock or debt investment in the subsidiary is eliminated from the FC’s assets for purposes of the asset test.
4. One Way Look Through Rule à only attributes from the lower tier entity to upper tier entity to test the upper tier entity to see if it is a PFIC. It doesn’t test the lower tier entity.

• §1298(b)(7) Treatment of Certain Foreign Corporations Owning Stock in 25% Owned Domestic Corporations—

1. This rule may apply if: (1) the FC owns at least 25% (by value) of the stock of a domestic corporation; and (2) the FC is subject to the accumulated earnings tax (under §531) or waives any U.S. treaty benefits, which would otherwise prevent the application of the tax
2. Rule: for purposes of applying Income and Asset tests to the FC, any “qualified stock” held by the 25% or more owned US Subsidiary is treated as an asset which DOES NOT produce passive income (and is not held for the production of passive income) AND any amount included in income w/r/t to the stock is NOT treated as passive income.
3. Impact of Rule: the FC is treated as owning a nonpassive asset through its U.S. subsidiary, if §1298(b)(7) applies.
4. “Qualified Stock” §1298(b)(8)—stock in a C corporation which is a U.S. corporation AND which is not a regulated investment company or real estate investment trust.
5. Policy: attempts to reduce the potential tax disparity of U.S. individual shareholders who hold US stock investments through a US holding company and those who hold such investments through a foreign holding company.
6. “Passive Income”—1297(b)

• General Rule—“passive income” means any income which is of a kind which would be foreign personal holding company income defined in §954(c) with 4 exceptions listed in §1297(b)(2)(A)-(D).
  • First 2 exceptionsà relate to income from the active conduct of a banking or insurance business—(A) and (B).
  • Exception 3 à covers interest, dividend, rent, or royalty income received from a related person (defined in §954(d)(3)) to the extent that such income is properly allocable (under the regs) to income of such related person that is NOT passive income—(C).
  • Exception 4 à covers certain foreign trade income subject to special treatment under 2 of the preferential tax regimes for export sales

1. Election Available—allows a FC to elect to apply the PFIC asset test using the adjusted bases of its assets (as determined for E&P purposes) in lieu of their value. Once made, it’s irrevocably w/o consent of the IRS.

• Election NOT Available—a publicly traded corporation is required to use the value of its assets in applying the asset test and cannot make the election to use adjusted bases. §1297(e)(1).

1. Tests for determining whether a FC is a PFIC are applied on a year by year basis. Thus, a FC may be a PFIC in some tax years and not in others.
   
   

• Special Rules Applicable to CFCs

1. If FC is a CFC (under §957(a)), the adjusted basis of the corporation’s assets for purposes of the PFIC ASSET TEST is MODIFIED to take into account certain research and experimental procedures and certain payments for the use of “intangible property” (defined in §936(h)(3)(B)) that is licensed to the CFC.

• 1^st—the aggregate adjusted basis of the TOTAL ASSETS of the CFC is INCREASED by the total amount of research and experimental expenditures made by the CFC in the current tax year and the two most recent prior tax years. §1298(e)(1)
• 2^nd—the aggregate adjusted basis of the total assets of the CFC is INCREASED by an amount equal to 3 times the total payments made during the tax year to unrelated persons and related U.S. persons for the use of intangible property w/r/t which the CFC is a licensee and which the CFC uses in the active conduct of its trade or business. §1298(e)(2).
  
  
• Special Rule for Start Up Year and Corporations Changing Businesses—

1. §1298(b)(2) Start Up—a FC is not treated as PFIC during the 1^st tax year that is has gross income (called the start up year) if 3 requirements are met:

• 1) no predecessor of the corporation was a PFIC
• 2) the corporation establishes to the satisfaction of the IRS that it will not be a PFIC for either of the first 2 tax years after the startup year; and
• 3) the corporation is NOT in fact a PFIC for either of the first 2 years after the start-up year

1. §1298(b)(3) Change in Business—a FC that is changing businesses is not treated as a PFIC for a tax year if 3 requirements are met

• 1) neither the corporation nor any predecessor was a PFIC;
• 2) the corporation establishes to the satisfaction of the IRS that (i) substantially all of its passive income for the tax year is attributable to the proceeds from disposition of one or more active trades or businesses; and (ii) it will not be a PFIC for either of the first 2 years after such year
• 3) the corporation is NOT in fact a PFIC for either of such two tax years
  
  

• Continuing Taint of PFIC State for Some Shareholders’ Stock

1. A FC may be a PFIC in some tax years and not in others
2. §1298(b)(1) provides the FC’s status as a PFIC for even a single tax year may continue to taint the SH’s stock even if the corporation does NOT meet the PFIC definition in any other tax year
3. Rule: stock held by a TP will be treated as stock in a PFIC, IF, at any time during the TP’s holding period for such stock, the corporation (or any predecessor) was a PFIC which was NOT a QUALIFIED ELECTING FUND.

• Thus, a TP subject ot this rule faces §1291 interest charge on deferred taxes when the shareholder disposes of the corporation’s stock or receives an “excess distribution.”

1. 2 Ways for TP to Purge PFIC Taint:

• 1) TP can elect Qualified Electing Fund treatment w/r/t the PFIC during all of the time that the shareholder holds the stock
• 2) TP can purge the PFIC taint by electing to recognize gain on the last day of the last tax year on which the corporation was a PFIC as if the stock had been sold for its FMV on that day
  
  
• Overlap Between CFC and PFIC Rules

1. A FC may be both a CFC and a PFIC
2. U.S. Shareholder under Subpart F vs. PFIC Inclusion à SubF WINS! No PFIC inclusion

• §1297(d)(1) provides that a FC will NOT be treated as a PFIC w/r/t a shareholder during the “qualified portion” of the shareholder’s holding period for the stock in the corporation.
• “Qualified Portion” of the holding period is the portion of the SH’s holding period AFTER 1997, during which the shareholder is a “U.S. Shareholder” (defined in §951(b)) AND the corporation is a CFC (defined in §957). §1297(d)(2)
  • Thus, a US SH that is subject to current inclusion under SubF rules w/r/t stock in a PFIC is NOT ALSO subject to the PFIC rules w/r/t such stock
  • U.S. Shareholder under Subpart F vs. PFIC Inclusion à SUBF WINS! No PFIC inclusion
  • PFIC rules continue to apply to other U.S. persons owning stock in the PFIC who are NOT U.S. Shareholders under §951(b) – i.e., owning less than 10% of a FC.
    
    

1. If shareholder loses “U.S. Shareholder” designation under §951(b) OR the PFIC is NOT LONGER a CFC—

• The holding period for the stock, for purposes of the PFIC rules, is treated as starting immediately after such cessation. §1297(d)(3)(A).
• If a U.S. person owning stock in a PFIC is subject to rules applicable to PFICs that are NOT “Qualified Electing Funds” BEFORE it is eligible for the special rule in §1297(d)(1), then the stock held by the shareholder continues to be treated as PFIC Stock.
  
  
• Rules for Attributing Stock Ownership

1. If treated as owner of PFIC under attribution rules in a PFIC that is a QEF—

• Amounts included in the U.S. person’s income under §1293(a) and distributions received by the U.S. person tax-free under §1293(c) will be applied to adjust the basis of the U.S. person’s property that gave rise to the attributed stock ownership in the PFIC. §1293(d).
• Example: if a US Person is a partner in a partnership which owns PFIC stock, §1293(a) current income inclusions will increase, and §1293(c) tax-free distributions will decrease, the U.S. person’s basis in the partnership interest.

Problems @ 6330

• (1) PFIC and CFC Comparison—FACTS: Compare the PFIC provisions w/ Subpart F provisions. What circumstances would be covered by the PFIC provisions that would not be covered by SubP provisions? Which is the best conceptual approach to dealing with the tax abuses that arise from the deferral of U.S income tax on a U.S. person’s share of passive income earned through a foreign corporation? Which is the most practical anti-deferral approach from the viewpoint of effective tax administration?

1. PFIC provisions apply even if no CFC status. Apply even to less than 10 percent ownership by U.S. shareholder in PFIC.
2. CFC applies to more income types. PFIC only applies to passive income.
3. PFIC ends benefits of deferral for all income of the PFIC, not limited to specified types of gross income. PFIC has a more complete termination of deferral of income recognition.
   
   

• (2) FACTS: Tax Avoidance (“TA”), a corporation incorporated under the laws of the Cayman Islands, has one class of stock outstanding, voting common, which is owned by the following shareholders:

1. 1) 40 shares by US Parent, a publicly held US corporation;
2. 2) 12 shares by Sam, a U.S. Citizen;
3. 3) 15 shares by Angelina, a nonresident alien, who is Sam’s sister;
4. 4) 9 shares by Wolfgang, a NRA;
5. 5) 18 shares by Foreign Venture, a foreign partnership with 2 equal partners—a) Alexandra, a U.S. Resident Alien; and b) Foreign Business Inc, a publicly held foreign corporation;
6. 6) 5 shares by USA, Inc a publicly held U.S. corporation
7. 7) 1 share by John, a U.S. Citizen

• Total Shares: 100 shares
• US Owned Shares: 40 + 12 + 5 + 1 + 9 (stock ownership through foreign partnership – owned proportionately under §958(a)(2)) = 67 shares by US
• “U.S. Shareholders” under §951(b) à US Parent and Sam
• (2) FACTS Continued: Except as otherwise indicated in the prior sentence, assume that the parties in this Problem are unrelated to each other and own no stock in any corporation except as expressly indicated.
  
  During the current year, TA has $10m of income having the following character: (*** assume for simplicity, TA has no allowable deductions for the year w/r/t the following income ***)

1. $4m in foreign-source dividends and interest from unrelated parties;
2. $1.5m in capital gains from the sale of foreign investment securities
3. $1m in income from a foreign business, which constitutes foreign base company sales income (w/in the meaning of 954(d));
4. $3.5m in income from an active foreign business which does NOT constitute foreign base company income (w/in meaning of 954(d)).

• Subpart F Income: $6.5m—
  • $4m foreign-source dividends and interest from unrelated parties (§954(c)(1)(A))
  • $1m income constituting Foreign Base Company Sales Income under §954(d).
  • $1.5m in capital gains from sale of foreign investment securities (§954(c)(1)(B))

During the current year, TA’s assets consist of the following:

1. assets that are using to conduct its trade or business activities, which have an average value of $60m and average adjusted bases of $30m;
2. assets producing passive income or held for the production of passive income, which have an average value of $50m and average adjusted bases of $30m

Questions:

1. (a) Is TA a CFC for the current year?

• Tax Avoidance is a CFC under §957(a):
• Two “United States shareholders” holding more than 50% = CFC:
  • US Parent owns 40 shares; AND
  • Sam (US citizen) owns 12 shares; no attribution to Sam from NRA sister - §958(b)(1).

1. (b) Is TA a PFIC for the current year?

• Tax Avoidance is a PFIC under §1297(a):
• Meets the 50% passive assets test (based on tax basis ratios).
• §1297(a)(2) & §1297(e)(2)(A).

1. (c) Do any of TA’s shareholders have inclusions under §951(a)(1)(A)? i.e., do they have CFC Income?

• U.S. shareholders are U.S. Parent (40%) and Sam (20%).
• They have constructive dividends for pro rata shares of Tax Avoidance’s $6.5 million Subpart F income:
  • (i) $5.5 million dividends & capital gains (§954(c)(1)(A) & (B)), and
  • (ii) $1 million FBC sales income (§954(d)).

1. (d) How would the PFIC provisions apply to TA’s shareholders under these facts?

• PFIC provisions apply without regard to the amount of ownership.
• But, not treated as a PFIC for those persons treated as U.S. shareholders of a CFC. §1297(e).
  • This is applicable to U.S. Parent & Sam.
  • Subject to PFIC Rules à (i) Alexandra (indirect ownership), (ii) USA, Inc., and (iii) John are subject to the PFIC rules.
    • Options for them: interest charge or Qualified Electing Fund. No “mark-to-market” option.

1. (e) How would your answer in (d) change if TA’s stock were regularly traded on a national securities exchange?

• Stock would constitute “marketable stock” within the meaning of §1296(e).
• Those shareholders subject to the PFIC rules could make the “mark to market” election under §1296.

Summary – Options for Foreign Income Taxation:

1. Current Full Inclusion

2. Subpart F Structure

3. Foreign corporation dividend exemption.

NEXT CLASS:

• Determine what happens to these people if 1m is distributed is distributed on 12/31/year 5
• 12/31/yr 1 – formed… it’s PFIC for the first year and every year after… only 12/31/year 5 distributes 1m proportionately to each shareholders… what are the consequences
• Delve much more deeply into §1291
• §1291 and relation to American Kennel Club… look in regs

1. Pedigree PFIC vs. Unpedigree PFIC

• Pedigree—
  • Not subject to §1291
  • Unpedigree—
    • Subject to §1291
    • Situation where TA was a PFIC formed on Jan 1 2000, nothing more happens to our shareholders, TA goes about its business, and then on 12/31/04, the last day of its 5^th year in existence, it distributes $1m proportionately to all its shareholders. What are the consequences to these various shareholders? Assume no one has made a QEF election.

1. USP and SAM – treated as a CFC, overlap rule applies, the distribution may or may not be a dividend, depending on whether USP picks up SubF income, no PFIC inclusion.
2. W and Angelina – not a US person, so §1291 doesn’t apply
3. Foreign Partnership –

• A would be treated as having 9 shares -- §1298(a)(3) – proportionate ownership
  • Deemed to receive her share of it, 1291 applies.
  • A pays amount of tax deferral plus interest charge attributable to the value of the tax deferral
  • FC deemed to own 9 – nothing happens to FC
  • TWIST: what if instead of foreign partnership, this was a foreign corporation? It would be the same treatment because A owns 50%, because the test in 1298(a)(2)(A) is 50% OR MORE. If A was only a 40% owner of the FC, then it’s not attributable to her, and A wouldn’t have income in PFIC.
  • TWIST: if FC is a PFIC, then the 50% limitation doesn’t apply, then A is deemed to own her proportionate share -- §1298(a)(2)(B). If the entity in which the US persons owns stock is a PFIC, then you have a straight proportionate look through under 1298a2B.
  • However we get there, if A is deemed to own some of the PFIC stock, then triggering events (disposition/distribution) fire off §1291.
    • Triggers (if FC is a PFIC)—

1. TA distributes 1m
2. FC gets rid of TA stock
3. John

• $1m distributed 12/31/05, John gets 1% -- $10k of that. Consequences to John?
  • 1291(a) applies

• Excess Distribution – 1291(b)
• Total Excess Distribution (b)(2)—

1. $10k over 125% of avg amount received during 3 preceeding taxable years
2. $10k = Total Execss Distribution

• Now, must allocate over entire holding period—

1. Allocate daily – but here it’s years, so same amount for each of 5 years, so $2k allocable to each year.

• 2 Things happen here:

1. 1) Included in Gross Income

• $2k from the year of the distribution plus any amount in TP’s HP that predates the company’s status as a PFIC à included in John’s gross income as ordinary income

1. 2) Payment of Deferred Tax plus Interest

• $2k from all other prior years ($8k total, 2000, 20001, 2002, 2003) à John incurs tax plus interest (the deferred tax amount) on those portions of the excess distribution, as provided in §1.1291-4.
• §1291(a) – tax imposed by the internal revenue code for the current year SHALL BE INCREASED by the Deferred Tax Amount under §1291(c)
• 1291(c)(2) – use highest rate of tax in effect for such year under §1 or §11, since John is an individual, use §1.

1. §1291(c) – Deferred Tax Amount to John

• Year                        Amt                        Tax Rate                        Tax                        Interest
• 2000                        $2000                        39.6%                        =            $792                        $190
• 2001                        $2000                        39.1%                        =            $782                        $141
• 2002                        $2000                        38.6%                        =            $772                        $93
• 2003                        $2000                        35%                        =            $700 $42
• $3,046                        $466
• Total Tax = $3,046         +         $466 = $3512 deferred tax amount
  • In addition, the Deferred Tax Amount has an INTEREST FACTOR
  • Calculate Interest—
    • How many years of interest owed for amount allocable in 2000?
    • Tax return for 2000 due April 15, 2001… so we’re going to impose interest on $792 as if it were owed in 2001..
    • What kind of interest? §6621 underpayment rate is the interest… compounds daily..
    • 4 years at 6% simple, would be 24% percent, so the interest would be $190

1. Total Tax Due in 2005 = 3,046 + 466 = 3512 (deferred tax amount that includes the interest component) + 700 (tax liability for the current year -- 35% highest tax bracket, assuming $2k was only gross income) = $4,212 is the total tax

• Variation: If $1m distributed in 2001 instead of 2004… assuming same facts… is there an excess distribution in which john gets his 10k? Is this an excess distribution? The excess is still $10k, b/c the prior 3 years (or his HP is shorter). Only difference is that would allocate 5k to 2000, and 5k to 2001. 5k of ordinary income in 2001, and the 5k in 2000 would be subject to the above calculations.
• Variation: No distributions in any of the years, 5 year holding period, and sells the stock for $10k on 12/31/2004.

1. Gain recognized from the disposition is treated as an “excess distribution” under §1291(b). Need to know John’s basis. If basis was 0, $10k is all excess distribution. If basis is $4k, excess is $6k.

• NEXT WEEK:

1. Chapter 10 – read through paragraph 10,120; problems at 10,120; problem handout – International Tax Free Transactions
2. No transfer pricing stuff