Early-stage startup companies can provide significant returns on investments, but they can also bring hefty and unexpected tax bills for unaware investors. Direct or indirect investments in foreign startups could trigger “passive foreign investment company” (PFIC) rules, which can impose taxes and penalties that outweigh expected returns.
PFIC rules are designed to prevent U.S. taxpayers from using a foreign corporation to defer U.S. federal income tax. But U.S. investors can easily trigger the PFIC designation for startups in which they are investing. That’s why it’s important to understand these rules as part of an overall tax strategy. Without an understanding of how these rules apply to foreign investments, U.S. investors run a risk of diminishing returns.
Common Traps for the Unwary
Taxpayers commonly overlook the following issues when investing in foreign startups:
- If a foreign investment is a PFIC, sale of the PFIC shares or dividends from the PFIC can result in ordinary gains (rather than favorable capital gains). This can have a significant impact on investor after-tax returns. There are several tax planning strategies to mitigate/manage this issue, but it generally needs to be addressed in the first year of investment.
- Even “operating” companies can be characterized as a PFIC. Some examples include:
- Non-capital intensive businesses (such as service companies) that are required to use tax basis in applying the asset test.
- Capital intensive startups that hold significant cash in early years.
- Businesses that don’t generate operating income in early years.
The following explanation of PFIC rules can help investors avoid companies with a PFIC designation or mitigate the impact of the designation.
What is a Passive Foreign Investment Company (PFIC)?
A foreign corporation is designated as a PFIC if it satisfies the “income test” or the “asset test.” Under these tests, a foreign corporation is a PFIC if at least 75 percent of its income comes from passive sources, or if an average of at least 50 percent of its gross assets produce passive income. The Internal Revenue Code defines “passive income” as any income received or accrued by any person that would be deemed foreign personal holding company income. This can include dividends, interest and gains from the sale of shares.
What are the Tax Consequences of PFIC Designation?
A PFIC designation results in increased taxes, penalties and interest charges. Any gain on the disposition of a PFIC ownership interest may be treated as an “excess distribution,” under which the amount is taxed at ordinary income rates instead of at capital gains rates and interest is assessed on the deferred tax. The distributions also do not qualify for treatment as a qualified dividend income (QDI).
Taxes under the “excess distribution” rules could exceed the total amount of the distribution or gain from the sale of the shares. In addition to the higher tax rates, an investor is subject to the PFIC tax treatment if the corporation was a PFIC at any time when the taxpayer held the stock, and the designation remains until the investor disposes of the security.
How are Startups Designated a PFIC?
Active startups could unintentionally become PFICs through the income test or the asset test in a number of ways.
Early-stage startups often have cash that exceeds other assets and often have no active business income. Under the rules, cash and marketable securities are generally treated as “passive” assets, with some exceptions. A startup with a balance sheet that is more than 50 percent cash or marketable securities could qualify as a PFIC if the assets produce passive interest income. Additionally, if a company does not have income from other sources, passive interest income from the cash or securities would be more than 75 percent of its gross income. The sale of a capital asset could also lead to a PFIC designation.
Are There Exceptions?
Controlled foreign corporations
Companies that are controlled foreign corporations (CFC) can avoid PFIC designation under certain circumstances. Shareholders with a 10 percent or more interest in a CFC in which other U.S. shareholders own and control the stock are not subject to the PFIC rules.
A startup can avoid the PFIC designation if all U.S. shareholders own their interest through a corporation that holds a 10 percent or more interest in the CFC.
Startup foreign corporations
There is a narrow exception for startups if they satisfy three conditions. A corporation is not a PFIC for its start-up year if:
- no predecessor of the corporation was a PFIC;
- the corporation makes assurances that it will not be a PFIC for either of the two taxable years following the start-up year; and
- the corporation is not a PFIC for either of the two taxable years following the start-up year.
How Can I Avoid PFIC Designation or Mitigate the Impact?
There are several ways that an investor can either avoid PFIC designation or mitigate the effects of the designation.
A QEF election
Investors in a startup that is designated a PFIC may be able to make a qualified electing fund (QEF) election.
The key benefit to this election is to preserve capital gain treatment when shares are sold (or for certain dividends). Additionally, eligible shareholders that make this election can avoid the deferred tax amounts and interest charges applicable under the default PFIC regime when no election is made.
The U.S. shareholder will be required to include in gross income on an annual basis, their attributable share of ordinary earnings and net capital gains of the PFIC. However, this cost is generally outweighed by the benefit received when exiting the investment.
The election applies to subsequent tax years unless the taxpayer revokes the election. A U.S. shareholder should make this election during the first year in which they own the PFIC stock to maximize the benefit.
Investors that hold marketable stock in a PFIC can make a mark-to-market election. Under this election, the investor includes ordinary gains or losses each year instead of incurring an “excess distribution” in a later year. To maximize the benefit, a U.S. shareholder should make this election during the first year in which the taxpayer owns the PFIC stock. A mark-to-mark election is considered when a QEF is unavailable. The benefit to this election is that it avoids the deferred tax amount and the interest charge, but unlike the QEF election, U.S. individuals who make this election will not be entitled to the lower capital gains tax rates.
Planning to mitigate the impact
Additionally, the “asset test” noted above to determine whether a foreign corporation might be a PFIC generally evaluates the gross assets at the end of each quarter to confirm whether those assets produce passive income. Therefore, companies may be able to plan and avoid classification as a PFIC by failing the “asset test,” depending on the facts. For example, a services company that is otherwise at risk of being designated as a PFIC could carry forward its receivable balances from one quarter to the next to increase its non-passive assets.
How Weaver can help
Weaver can help investors avoid the tax and penalty implications of PFIC treatment by determining if their investment will be considered a PFIC and, if so, implementing ways to reduce the impact of a PFIC designation. Additionally, we assist with any required tax reporting of the PFIC investment. In addition to our PFIC tax services, we help early-stage startup companies in financial and tax matters from emerging growth through expansion and to full maturity. Contact us for information.