Feb 6, 2024 Passive Foreign Investment Companies (PFICs): What are they, and why are they a bad investment?
Do you have a private kupat gemel l’hashkaa open? Do you have kranot ne’emanut or kranot sal investments in the bank? Are you aware that these can be some of the worst investments to hold as a U.S. citizen? These investments are almost always passive foreign investment companies (PFICs).
Having been assisting U.S. citizens in Israel for over 40 years, we often see individuals inadvertently falling into the pitfalls of Passive Foreign Investment Companies (PFICs). Especially for those living in Israel with money to invest, it makes sense that they would invest in PFICs since the returns look fantastic compared to other investments. While these investments might seem lucrative, they come with a hefty price for U.S. citizens — two major tax issues and an administrative headache. In this article, we’ll dissect the PFIC problem and explain why you likely want to choose something else to invest in. We’ll get it sorted out for you and explain other options for investment possibilities.
Understanding PFICs:
The allure of PFICs often lies in their promising returns. Common PFICs include investments like kranot neemanut, kranot sal, ETFs, and various pooled funds like kupot gemel l’hashka’a or a tik hashkaot. Even private keren hishtalmut accounts fall under this category. The catch? Their structure often leads to unintended tax consequences for U.S. investors.
Challenges for U.S. Citizens
For U.S. citizens, holding more than $25K in PFICs, triggers complex reporting requirements. Each investment must be detailed annually on Form 8621. The tax implications are even more daunting:
No Losses Offset:
You can offset both U.S. and Israeli taxes with other capital gains with capital losses from other investments. You can also offset PFIC gains with other stock losses for Israeli taxes. This is because Israel doesn’t recognize anything wrong with PFICs. For U.S. tax purposes, though, you can’t offset one PFIC’s losses against another’s gains. You can’t offset those PFIC gains with any type of losses. This often leads to no Israeli taxes being paid, leaving a hefty U.S. tax.
Highest U.S. Tax Rates:
While other shares, if sold after a year, can generate long-term capital gain rates of 20%, PFICs have no such luck. PFIC gains are broken out over the entire holding period and allocated to each year proportionally. Then, each prior year’s portion is taxed at the highest tax rate possible. To add salt to the wound, the IRS also charges you interest on those “prior year” gains. Outcome: A possible tax rate exceeding 37% on gains, significantly higher than non-PFIC investments.
As an example, imagine that you held two kranot neemanut in your bank for the past 4 years, and sell both of them. One for a loss of $50 and the other for a gain of $225. In Israel, they net against each other, and the net $175 gain is taxed at 25% or $43.75.
For U.S. tax purposes, you can only use the $50 loss against other non-PFIC gains. The $225 PFIC gain is then split over the past 4 years. The prior 3 years, or $168.75, are taxed at 37% plus interest. The remaining $56.25 or 1/4 of the profit is taxed at ordinary tax rates and not capital gain rates. The end result is likely more than double the Israeli tax rate.
While you can offset the U.S. tax with the Israeli taxes paid on the PFIC gain, you will still owe Uncle Sam a lot of tax. I bet those promised higher profits of PFICs aren’t looking as attractive now. So, what can you invest in instead? Good question.
We delve into some safe investments in our post here.
