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PFIC calculations: the IRS gets hoisted by its own petard

by: Anthony Parent   2018-09-20

We congratulate our colleagues, tax attorneys Robert S. Schwartz & Elizabeth C. Petite, on a great win in US tax court in the case of Roberto Toso and Marcela Salman v. Commissioner, US Tax Court, Dkt. 8324-15 151 TC ___ No. 4, September 4, 2018. What makes their win so refreshing is that the convoluted Passive Foreign Investment Company (PFICs) reporting rules are the exact reason why the IRS was forbidden from going way back to assess additional taxes.

 

 

How some PFIC income enters into a tax return

 

PFICs, are usually foreign mutual funds, but can occur whenever you have an investment overseas that someone else manages. The PFIC concept was contrived by the 1986 Tax Reform. Proponets of PFIC taxation claim that it levels the playing field between foreign mutual funds and domestic mutual funds. Detractors claim it was a pure protectionist move that favors Wall Street. Whatever the case, PFICs are undoubtedly complicated. In particular, there are at least three areas of a return where PFIC incomes come in. Yet and here's the key: Sometimes PFIC income affects Adjusted Gross Income, but sometimes, believe it or not, it does not.

 

Not all PFIC income goes into your Adjusted Gross Income. Yet taxes are most certainly due.

 

The above statement would sound ludicrous to anyone who studies US taxation. As the fundamental concept is that Adjusted Gross Income (AGI) is used to calculate taxable income, which is used to calculate the taxes owed.

 

Yet, because of the convoluted nature PFICs, certain tax liabilities bypass the standard Adjusted Gross Income/Taxble Income/Taxes Due formula. Form 8621, which is usually required when you own PFICs, will calculate a tax liability due based on "excess distributions." This tax liability is then put on page two of a tax return.

 

To restate, what this means is that the tax due is put down on form 1040, but the income that generated that tax liabilty might not affect AGI, as it is not to be found anywhere on a Form 1040.

 

This phenomeneon makes it is possible for someone who is heaviliy invested in PFICs to have an AGI that is incredibly low, but still have tax is that is astronomical.

 

For instance, a taxpayer with $10 million of PFIC income may only have an Adjusted Gross income of $100,000, but still have a tax liability in the millions.

 

So what makes this interesting is that for the IRS to examine or audit a taxpayer for more than 3 years back, the IRS must show that the taxpayer engaged in fraud or understated income by 25% or more.

 

So the question is, does unreported PFIC income, the type of which does not affect an AGI, count towards the 25% minimum?

 

Which brings us back to Toso & Salman v. Commissioner. In this case,  the tax court said no, unreported PFIC income which does not affect AGI can not be used a basis to open up an examination on the basis of a 25% or more substantial understatement.

 

(For more on how these assessments statutes of limitation work, our article on how long to keep tax records does a great job explaining the landscape)

 

The IRS argued public policy reasons, but the tax court wasn't haven't any of it. Because if the tax court to agree with the IRS, this would require an entirely additional definition of AGI, which would likely only lead to more problems.

 

The first mention of the HIRE Act with regards to foreign informational reporting.

 

The HIRE Act of 2010 had a few items that leave much to be desired. One is the Foreign Account Tax Compliance Act which was tacked on a "paygo" offset. The other is that the HIRE Act made it so that if any foreign informational return (for example, Form 8938, Form 5471, Form 5472, Form 8865, Form 8858, Form 926, Form 3520, Form 3520-A) was due, but not filed, or filed substantially incomplete, the IRS could keep the entire tax return open for audit indefinitely.

 

So in a case that appears to be one of first impression, the tax court ruled that the HIRE Act only applies to assessment statutes that were open when the HIRE Act was passed in 2010. 

 

It is important to note that post-2010, any unfiled foreign informational return can keep an assessment open indefinitely. For instance, if the issues where the same but assume the IRS is attempting to audit tax year 2011 in 2018, the IRS would likely be able to do so as a sunstanitally incomplete Form 8621 is one of those forms that will keep a tax return open for exam indefinitely. Unlike Toso & Salman, the IRS would not need to prove substantial understatement in order to audit 2011. 

 

For taxpayers worried about old tax years coming back to haunt them, it is important to note that should a proper disclosure be made to the IRS, all open years will be closed, even if there is unreported income.


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