On January 25, 2022, the IRS published final regulations requiring aggregate treatment for subpart F and 956 inclusions.. Simultaneously, it issued proposed Passive Foreign Investment Company (PFIC) regulations extending the aggregate treatment to partnerships holding stocks in PFICs. S corporations are treated like domestic partnerships for the purposes of these regulations. Both the final and proposed regulations are relevant to any domestic partnership or S corporation that owns stock in a foreign corporation. Today’s blog analyzes the impact of the proposed regulations on indirect investments in PFICs through domestic passthrough entities (i.e., partnerships and S corporations).
Under the current PFIC regulations, PFIC shareholders subject to Subpart F inclusion rules are not subject to the PFIC rules under the controlled foreign corporation (CFC) overlap rule. Direct and indirect shareholders in PFICs are generally required to file Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund). If a domestic partnership or S corporation files Form 8621 for a PFIC, however, its partners (and indirect shareholders of the PFIC) need not file the form for that PFIC.
The Proposed PFIC Regulations
The proposed regulations clarify that the CFC overlap rule does not apply to domestic partnerships and is applied at the partner level., This aggregate treatment has several consequences. By treating partners and S corporation shareholders as if they owned their PFIC stock directly, the proposed regulations provide that only such partners or shareholders would make certain elections associated with PFIC ownership, such as the Qualified Electing Fund (QEF) and Mark-to-Market (MTM) elections. As a result, partners and shareholders that make QEF or MTM elections would have to separately file Form 8621 with respect to PFICs owned directly by their domestic partnerships or S corporations. The regulations provide an exception for partners and S corporation shareholders that are domestic non-grantor trusts or estates, which continue to be treated as entities for purposes of PFIC income inclusions or elections. Consequently, a domestic non-grantor trust or estate may continue to make QEF or MTM elections.
Under the proposed regulations, partners and S corporation shareholders who make QEF or MTM elections would be required to notify the partnership or S corporation “in any reasonable manner” (e.g., via mail and e-mail) within 30 days of filing the return making the election. The election would not be invalidated by the failure to provide the notice. QEF or MTM elections made by domestic partnerships and S corporations before the proposed regulations are finalized will be deemed to have been made by their partners and S corporation shareholders.
In response to practitioner comments regarding the administrability of partner-level QEF elections, the U.S. Treasury Department and the IRS have solicited comments on whether the final regulations should permit a domestic partnership – or S corporation – level QEF elections on behalf of its partners or shareholders, respectively, in conjunction with the general rule requiring the partner or shareholder to make the election. Likewise, the U.S. Treasury Department and IRS have solicited similar comments with respect to the permissibility of partnership and S corporation-level MTM elections on behalf of their partners and shareholders, respectively.
When finalized, these regulations will apply to taxable years beginning on or after the date of publication of the final regulations in the Federal Register.
Impact of the Proposed PFIC Regulations
The proposed regulations create a seismic shift in the compliance and reporting obligations associated with the ownerships of stocks in PFICs. By shifting these obligations from U.S. domestic partnerships and S corporations to their partners and shareholders, respectively, the proposed regulations will greatly increase the number of Forms 8621 that would have to be filed. This will increase the compliance costs associated with PFIC investments. It is helpful that the Treasury Department and IRS are considering preserving, in the finalized version of the regulations, the current domestic partnership and S corporation-level reporting and compliance regime, albeit on an elective basis under the finalized regulations (i.e., partners or S corporation shareholders would have to elect for the partnership or S corporation level reporting regime for it to apply). This elective entity level compliance and reporting regime will ensure that the benefits of the current regime (e.g., administrability and cost-effectiveness) will continue in certain circumstances under the new regime the finalized regulations will implement.
Once the proposed regulations are finalized, it will become risky for partners or S corporation shareholders in a partnership or S corporation that owns a PFIC to file their tax returns before the partnership or S corporation has completed its international tax analysis. A partner or S corporation shareholder who does so may lose the ability to make a QEF/MTM election, which must be made on a timely filed original return.
We will keep monitoring developments regarding the proposed PFIC regulations, and we are available to assist businesses and their owners with advice on how these regulations may impact them. If you would like to discuss how these regulations may affect your business operations, please reach out to the author (firstname.lastname@example.org; 215.665.3960).