On Warren Buffett, Berkshire Hathaway and PFICs

We have spoken before about passive foreign investment companies, or PFICs (pronounced pea-fick). There was a time when I saw these on a regular basis, and I remember wondering why the IRS made the rules so complicated.

I am thinking about PFICs because yesterday I read a release for IRS Notice 2014-28. The IRS is amending Regulations concerning the tax consequences of U.S. persons owning a passive foreign investment company through an account or organization which is tax-exempt. Think a hospital, pension plan or IRA, for example. 

Granted, this is not as interesting as Game of Thrones or Sons of Anarchy.

Could you walk unknowingly into a PFIC? It is not likely for the average person, but it is not as difficult as you might think.

PFICs came into the tax Code in 1986. They were intended to address what Congress saw as a loophole. I agree that there was a loophole, but whether the tax fly required the sledgehammer response it received is debatable.

There were a couple of ways to get to the loophole. One way would be to form a foreign corporation and have the corporation invest in stocks and bonds. This means you are forming a foreign mutual fund. There are a couple of issues with this, the key one being that it would require a large number of investors in order to avoid the rules for a controlled foreign corporation. To the extent that 10%-or-more U.S. shareholders owned more than 50% of the foreign corporation, for example, one would have a controlled foreign corporation (CFC) and would be back into the orbit of U.S. taxation.

The second way is to invest in an existing foreign mutual fund. Say that you invested in a German fund sponsored by Deutsche Bank, for example.

And the average person would say: so what? You invested in mutual fund.

Here s what the IRS did not like: the mutual fund could skirt the taxman by not paying dividends or distributions.  The value of the fund would increase, as it would accumulate its earnings.  When you sold that foreign mutual fund, you would have capital gains and you would pay U.S. tax.

Well, the IRS was unhappy with that, as you did not pay tax on dividends every year and, when you did pay, you paid capital gains rather than ordinary income tax. How dare you?

Why the sarcasm? Because you can get the same tax result from owning Berkshire Hathaway. Warren Buffet does not pay a dividend, and never has. You hold onto your shares for a few years and pay capital gains tax when you sell. The IRS never receives its tax on annual dividends, and you pay capital gains rather than ordinary tax on the sale.

Why the difference between the Berkshire Hathaway and Deutsche Bank? Exactly my point. Why is there a difference?

So we have PFIC taxation. Its sole purpose is to deny the deferral of tax to Americans investing in foreign mutual funds.

There are three ways to tax a PFIC.

The default scheme is found in Code Section 1291. You are allowed to defer taxation on a PFIC until the PFIC makes an “excess” distribution. An excess distribution is defined as one of two events:

(1)   The PFIC distributes an amount in excess of 125% of the average distribution for its preceding three years; or

(2)   You sell the PFIC stock.

Let’s say that we use the default taxation on the PFIC. What does your preparer (say me) have to do next?

(1)   I have to calculate your additional tax per year had the distribution been equally paid over the period you owned it (this part is relatively easy: it is the highest tax rate for that year); and

(2)   I have to calculate interest on the above annual tax amounts.

You can imagine my thrill in anticipation of this magical, career-fulfilling tax opportunity. There are severe biases in this calculation, such as presuming that any income or gain was earned pro rata over your holding period. I have seen calculations where - using 15 to 20 year holding periods - the tax and interest charge can approach 100%. This is not taxation. This is theft.

The second option is to annually calculate a "mark to market" on the PFIC. This works if there is a published trading or exchange price. You subtract the beginning-of-year value from the end-of-year value and pay tax on it. I have never seen a tax professional use this option, and frankly it strikes me as tax madness. With extremely limited exceptions, the tax Code does not consider asset appreciation to be an adequate trigger to impose tax. There would be no 401(k) industry, for example, if the IRS taxed 401(k)s like they tax PFICs.

The third option is what almost everyone does, assuming they recognize they have a PFIC and make the necessary election to be taxed as a “qualified election fund,” or QEF for short.

   OBSERVATION: Tax practitioners like their acronyms, as you can see.

There are two very important factors to a QEF:

           

(1)   You have to elect.

a.     No election, no QEF.

(2)   The foreign fund has to agree to provide you numbers, made up special just for its American investors. The fund has to tell you what your interest and dividends and capital gains would have been had it actually distributed income rather than accumulate.

You can fast forward why: because you are going to pay tax on income you did not receive.

What happens in the future when you sell the fund? Remember, you have been paying tax while the fund was accumulating. Don’t you get credit for all those taxes when you finally sell?

Yes, you do, and I have to track whichever of three calculations we decide on in a permanent file. For every fund you own.

BTW there had better be a specific form attached to your tax return: Form 8621. If you were required to disclose a foreign financial account (which a PFIC would be) and did not do so, either on Form 8621 or on another form intended for that purpose, the IRS might be able to "toll" the statute of limitations. Tolling means "suspend" in tax talk. This means the IRS could assess taxes, penalties and interest many years after the tax year should normally have closed. 

This applies only to rich people, right? Not so much, folks. This tax pollution has a way of dissolving down to affect very ordinary Americans.

How? Here are a couple of common ways:

(1)   You live abroad.

You live abroad. You invest abroad.

I intend to retire abroad, so some day this may affect me. Me and all the other tax CPA billionaires high-stepping it out of Cincinnati. Yep, we are a gang of tax-avoiding desperados, all right.

(2)   You work/worked in Canada.

And you have a RSSP. The RRSP is invested in Canadian mutual funds. How likely is this to happen? How about “extremely likely.”

There you have two ordinary as rain ways that someone can walk into a PFIC.

Keep in mind that the IRS is convinced that anyone with a nickel overseas is hiding money. We have already gone through the FBAR and OVDI fiascos, and tax literature is thick with stories of ordinary people who were harassed if not near-bankrupted by obscure and never-before-enforced tax penalties. The IRS is unabashed and wonders why you – the average person – cannot possibly keep up with its increasingly frenetic schedule of publishing tax rules, required disclosures, Star Trek parodies, bonuses to deadbeat employees and Fifth Amendment-pleading crooks.

Beginning in 2014, FATCA legislation requires all “foreign financial institutions” to report to the IRS all assets held by U.S. citizens and permanent residents. The U.S. citizen and permanent resident in turn will disclose all this information on new forms the IRS has created for this purpose – assuming one can find a qualified U.S. tax practitioner in Thailand, Argentina or wherever else an American may work or retire. Shouldn’t be a problem for that overseas practitioner to spot your PFIC – and all the related tax baggage that it draws in its wake - right?

What happens if one doesn’t know to file the PFIC form, or files the form incorrectly? I think we have already seen the velvet fist of the IRS with FBARs and OVDI. Why is this going to be any different?

Taxation and Renouncing Citizenship: Part II

Let’s say that you were born in Brazil. Your family was wealthy. Due to safety concerns (such as the risk of kidnapping), they moved you to the United States when you were young. You grew up in a southern and international city – perhaps Miami. You went to Harvard. While there you met and bankrolled a cantankerous near-friendless computer genius who came up with the next great social media idea. He tried to boot you out of the fledging company, but after a lawsuit and hard feelings, you kept about 4% or so of the shares. Much to your delight, the company went recently went public and made you a multibillionaire. Prior to that, you met with high-powered attorneys and tax advisors. You renounced your U.S. citizenship and are now living in Singapore. Where is Singapore? Think Vietnam, and then turn south. It is a former British colony, and you like pasties and room-temperature beer. Seems a fit.

Why would you do this?

Let’s go over several tax reasons. We need numbers in this conversation. Let’s use the following:

            Proceeds from IPO                          $ 4.0 billion

            Expected annual salary                     $ 7.5 million

            Expected annual dividends               $ 40 million

            Expected capital gains                      $ 25 million

What are your U.S. 2013 taxes if you remain a U.S. citizen?

(1)   Your salary may be taxed as high as 39.6% next year. Let’s say that it will be. The federal tax would be $7,500,000 times 39.6% equals $2,970,000.

(2)   If your dividends are “qualified” dividends, you would pay a 15% tax rate this year. The President’s proposed 2013 budget would increase this to 39.6%. In previous budgets, however, he has proposed 20%. What rate should we use? Let’s use 20%.  Your tax would be $ 40,000,000 times 20% equals $8,000,000.

(3)   The capital gains are a wild card. Let’s say that you will be selling stock periodically to fund your lifestyle. What amount? Let’s say $25 million annually. Let’s also say that your basis is so low that any sale is virtually all gain. The long-term capital gains rate is currently 15%, but everyone expects this rate to go up. Unless Congress acts, the rate will increase to 20% in 2013. Let’s use 20%. Your tax would be $5,000,000.

(4)   Starting in 2013, there is a new surtax on investment income if your income exceeds either $200,000 or $250,000, depending on filing status. You have clearly blown past that speed bump like Steven Tyler’s new Hennessey Venom GT Spyder. That new tax is 2.9% and will cost you $1,885,000.

(5)   Starting in 2013, there is a Medicare surcharge for persons earning more than $200,000. The surcharge is 0.9% and will cost you $67,500.

What are your 2013 taxes in Singapore?

(1) The top tax rate in Singapore is 20%. Taxes on your salary will be $1,500,000.

(2) Taxes on your dividends will be $8,000,000.

(3) There are no taxes on your capital gains.

OK, let’s look at the scorecard. A quick back-of-the-envelope calculation shows:

            United States              $ 17,922,500   

            Singapore                   $  9,500,000

Is there more? Well, yes.

(1) Let’s say that you invested in mutual funds to obtain those dividends. Chances are these funds will be considered PFIC’s (“pea-fics”) and carry some heavy U.S. tax disapproval.

The best you can do with a PFIC is make a QEF election and pay taxes every year on your share of income, whether distributed to you or not. This requires the PFIC manager to want to go to the trouble of assembling this information for you, as the PFIC tax is an American concept. A fund manager in Hong Kong, for example, might be less than interested in IRS mandates. In any event, the U.S. wants to accelerate your tax without regard to whether you received any cash.

If the fund manager is unwilling, you go to an ugly place in U.S. taxation. Without belaboring this, it may require you to go back and recalculate your prior year taxes on an “as if” basis. You will then write a real check to the IRS for that “as if” calculation. You also have to pay the IRS interest for not having paid taxes in the earlier “as if” tax year.

(2) Don’t forget your FBAR filing every June 30.

You have financial accounts overseas, so you will have an FBAR filing.

Penalties for failure to file an FBAR border can be severe. Penalties begin at $10,000 for each non-willful violation. If willful, the penalty goes to the greater of $100,000 or 50% of the account for each violation. Oh, each year is considered a separate violation. And the IRS gets to decide what is willful.

You got it: if the IRS considers your violation to be willful for two years, you have wiped-out the account.

(3)   You have to file the new Form 8938 disclosing foreign financial assets.

This is the FATCA and its reason for existing reads like a bad dream. In essence, the IRS felt that it was not getting enough information from the FBAR, and it really wanted more information. Think about this. The FBAR is mailed to the U.S. Treasury, and technically the IRS is part of the U.S. Treasury. One would think that the IRS and Treasury would speak, perhaps weekly for breakfast. Treasury did not upgrade the FBAR, nor did it replace the FBAR with the IRS Form 8938. No sir, the IRS created a new form and they kept both filing requirements. Well, it is one more opportunity to confuse the populace and maximize those penalty dollars. Brilliant!

Penalties can be rough: $10,000 for each failure to file. If you both fail to file the 8938 and fail to pay tax on the foreign income, there is a super-penalty of 40% on the tax underpayment. Don’t do that.

(4)   Should you leave family behind, gifting to them will certainly be a problem. These transfers will be picked up under the expatriation rules of Section 877 and trigger tax at the maximum gift tax rate. That rate is currently 35% but is expected to increase to 55% next year.

You read that right: Uncle Sam is your biggest beneficiary. More so than your mom, son or daughter. 

You may want to take them with you.  Singapore has no gift tax.

(5)   Should you remain a U.S. citizen, consider hiring an experienced tax attorney and/or CPA to navigate all this. It is another expense, but least you can write-off the professional fees on your taxes. Oh, wait. No you can’t. Chances are the fees will not exceed 2% of your income. If you are in the AMT, they will not be deductible in any event.

There are reasons other than taxation to renounce. There are many expatriates overseas who have no intention of returning to the U.S. They have lives, spouses, children, jobs and friends there. Perhaps they will return, but it will be at some unknown and distant date.

It is unfortunate to renounce citizenship over tax reasons. The U.S. does press your hand by taxing you on your worldwide income, irrespective of where you live, work or maintain family. The U.S. is virtually alone in the world with this type of taxation. If this ever made sense, does it still make sense? Leaving the U.S. doesn’t mean that you leave its mandates. You have to renounce.

What would you do?

Foreign Mutual Funds

Let’s talk about PFICs.

It is pronounced “Pea Fick,” and it is shorthand for a passive foreign investment company. We are continuing our “foreign” theme of late.

A PFIC is a foreign mutual fund. Think about your funds at Fidelity or Vanguard and relocate them to Bonn or London. That is all you have done, but with that act you have entered a twilight world of odd tax reporting.

Why? Treasury does not like foreign mutual funds. Why? That question has several possible answers, but I believe that a large part is because Treasury cannot control the taxation. A mutual fund in the United States is a “regulated investment company.” One of the requirements is that it has to pass along its taxable income to its investors in order to preserve its tax standing. Shift that fund to Bonn, and the German fund manager may not have the same level of concern in maintaining that “regulated investment company” status. The German fund manager may do something unconscionable, such as not declare dividends or distribute income to investors. That would allow the German fund to delay tax consequence to its U.S investors, possibly for many years. Why, the U.S. investor may eventually report the income as capital gain rather than ordinary dividend income. This is clearly an unacceptable scenario.

It didn’t use to be this way. The law for PFICs changed in 1986.

You are going to be specially taxed. You however can choose one of three methods of taxation:

(1)    The Excess Distribution Method

This is the default method and is found in Section 1291 of the Internal Revenue Code.

At first glance it sounds good. You pay no tax until you either sell or receive an “excess distribution.” When you do, the IRS presumes that the income was earned ratably over the years you owned the fund. You have to pay tax at the highest marginal tax rate. It does not matter what your actual tax rate was. What if the fund lost money for 8 years, had one great year that made up for all losses and then you sold at a profit. ? Doesn’t matter. The IRS presumes that your profit was earned pro rata over 9 years. Now you are late on your taxes (remember, you did not include the profit in your prior year returns because there WAS NO PROFIT). You now have to pay tax using the highest-marginal tax rates. For 9 years. And then there is interest on the late taxes.

Oh, you may not be allowed to claim the loss if you sell the PFIC at a loss.

 You really do not want to use this method.

(2)    The Mark to Market Method

This option was added to the Code in 1997.

You mark your PFIC to market every year-end. In other words, you pay taxes on the difference between the share price on January 1^st and December 31^st. Every year.

You forfeit capital gains and losses. Whatever income or loss you report is ordinary. Sorry.

The big requirement here is that the PFIC has to have published fund prices. If the prices are not published, you simply cannot use the mark to market method.

(3)    The Qualified Electing Fund

This is the method I have normally seen. The problem is that the fund has to provide certain information annually. As that information has meaning only to a U.S. taxpayer, the fund may decide that it is not worth the time and cost and refuse to provide it. In practice, I have seen these funds go through investment houses such as Goldman Sachs. Goldman can pool enough U.S. investors to make it worthwhile to the foreign fund manager, so the fund agrees going in that it will provide this additional information annually.

A QEF is basically like a partnership. It passes-though its income to the U.S. investor – whether distributed or not – and the U.S. investor pays taxes on it. Ordinary income is taxed at ordinary rates, and capital gains at capital gains rates. What changes is that Treasury does not wait for a distribution.

A QEF should be elected in the first year you own the QEF. If so, you avoid the “excess distribution” regime altogether. If you make the election in a later year, then there is a procedure to “purge” the earlier PFIC treatment.

The QEF election is made fund by fund.

Yes, there is a special form to use with PFICs. It is Form 8621 “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.” It can be an intimidating three pages of tax-speak.

I saw PFICs a few years back, as we had several well-heeled clients. What I generally saw was a K-1, perhaps from a hedge fund. That fund in turn invested, and some of its investments were PFICs. The fund K-1 would arrive with its booklet of information, explanation and disclosures. The PFICs inside would further swell the page count. I remember these K-1s going on for 30 or 40 pages. These K-1s are not for young tax accountants.

As I said, Treasury really does not like foreign mutual funds.