A Guide to PFIC

When making investment decisions, venture investors typically focus on companies with high growth potential. However, some investors seek out tax-efficient investments that generate passive income outside the US. In 1986, in an attempt to close a loophole that created certain tax advantages, the IRS created a designation of passive income investments called PFICs, or Passive Foreign Investment Companies.

What are PFICs?

PFICs are non-U.S. based companies that either (i) generate 75% of gross income from “passive income” sources or (ii) use 50% of the company’s assets to generate “passive income.” Generally, passive income is income generated from sources that are not related to the company’s regular business operations. Principal forms of passive income as they relate to PFICs include interest, rents, royalties, capital gains, currency gains, and dividends. In general, most investors want to avoid PFICs because the IRS taxes gains from these investments at the ordinary income tax rate, as opposed to the lower capital gains tax rate.

How do PFICs apply to venture investments?

When investing outside of the US, VCs should be aware that some companies can inadvertently fall under the definition of a PFIC. Most commonly, PFIC designation may arise when an early-stage company is in a research and development stage and is therefore not generating any revenue from their regular business operations. For example, let’s say a company has raised millions from outside investors on a promising new product or service. The company generally will not spend all the money immediately, so excess cash is put into interest-bearing accounts until needed. Since the only income being generated is from interest on the deposits, this would fall into the first condition “generating 75% of gross income from passive income.” Further, it could fall into the second condition where 50% of the assets (most likely only cash raised) are generating passive income. Fortunately, the IRS has since created exceptions that help alleviate some of the traps that could catch non-US companies in PFIC classification.

What to look out for?

While it’s typically pretty easy to avoid PFIC restrictions when investing directly via an SPV or fund, an SPV investment into a fund (“fund of funds”) has the potential to trigger PFIC. SPVs are considered “look-through” vehicles for tax purposes, so it’s important to look at the underlying investment (especially if it is a foreign fund). If the company receiving the investment is a PFIC, investors must determine whether they are direct or indirect shareholders of the PFIC. In general, investors using Sydecar’s platform would not be “direct” shareholders of any PFIC since shareholders only own interests in SPVs. That said, a final determination is typically made by speaking directly with the company receiving investment.

How are PFICs treated for tax purposes?

If it is determined that an investment is a Passive Foreign Investment Company, there are three different ways a taxpayer can elect:

The Excess Distribution Regime: This is the default tax treatment and usually results in a larger tax burden. Generally, this election allows you to defer taxes (pay them later), but when taxes are due, they are very steep and include interest charges.
Qualified electing fund: A taxpayer must elect into this treatment. This method more closely follows US tax treatment of passive income with long-term capital gains retaining their favorable treatment. This is the most common PFIC election.
Mark to Market for Marketable Stocks: If a taxpayer’s holdings are regularly traded, they can elect this method. Basically, the taxpayer adds up all their gains and losses (realized & unrealized) each year and the result is taxed at higher ordinary income rates. Losses can only reduce gain to zero. This method is perhaps the most difficult to assess favorability.

What is Sydecar doing to avoid PFIC investment issues?

At this time, Sydecar has made a policy to not support SPV investments into PFICs, but we are here to help you find the resources that can help with the PFIC rules. If you indicate the target company is a PFIC, it’s important to understand the IRS Form 8261 filing requirement.

Where can I go for more information?

When making investment decisions, venture investors typically focus on companies with high growth potential. However, some investors seek out tax-efficient investments that generate passive income outside the US. In 1986, in an attempt to close a loophole that created certain tax advantages, the IRS created a designation of passive income investments called PFICs, or Passive Foreign Investment Companies.

What are PFICs?

PFICs are non-U.S. based companies that either (i) generate 75% of gross income from “passive income” sources or (ii) use 50% of the company’s assets to generate “passive income.” Generally, passive income is income generated from sources that are not related to the company’s regular business operations. Principal forms of passive income as they relate to PFICs include interest, rents, royalties, capital gains, currency gains, and dividends. In general, most investors want to avoid PFICs because the IRS taxes gains from these investments at the ordinary income tax rate, as opposed to the lower capital gains tax rate.

How do PFICs apply to venture investments?

When investing outside of the US, VCs should be aware that some companies can inadvertently fall under the definition of a PFIC. Most commonly, PFIC designation may arise when an early-stage company is in a research and development stage and is therefore not generating any revenue from their regular business operations. For example, let’s say a company has raised millions from outside investors on a promising new product or service. The company generally will not spend all the money immediately, so excess cash is put into interest-bearing accounts until needed. Since the only income being generated is from interest on the deposits, this would fall into the first condition “generating 75% of gross income from passive income.” Further, it could fall into the second condition where 50% of the assets (most likely only cash raised) are generating passive income. Fortunately, the IRS has since created exceptions that help alleviate some of the traps that could catch non-US companies in PFIC classification.

What to look out for?

While it’s typically pretty easy to avoid PFIC restrictions when investing directly via an SPV or fund, an SPV investment into a fund (“fund of funds”) has the potential to trigger PFIC. SPVs are considered “look-through” vehicles for tax purposes, so it’s important to look at the underlying investment (especially if it is a foreign fund). If the company receiving the investment is a PFIC, investors must determine whether they are direct or indirect shareholders of the PFIC. In general, investors using Sydecar’s platform would not be “direct” shareholders of any PFIC since shareholders only own interests in SPVs. That said, a final determination is typically made by speaking directly with the company receiving investment.

How are PFICs treated for tax purposes?

If it is determined that an investment is a Passive Foreign Investment Company, there are three different ways a taxpayer can elect:

The Excess Distribution Regime: This is the default tax treatment and usually results in a larger tax burden. Generally, this election allows you to defer taxes (pay them later), but when taxes are due, they are very steep and include interest charges.
Qualified electing fund: A taxpayer must elect into this treatment. This method more closely follows US tax treatment of passive income with long-term capital gains retaining their favorable treatment. This is the most common PFIC election.
Mark to Market for Marketable Stocks: If a taxpayer’s holdings are regularly traded, they can elect this method. Basically, the taxpayer adds up all their gains and losses (realized & unrealized) each year and the result is taxed at higher ordinary income rates. Losses can only reduce gain to zero. This method is perhaps the most difficult to assess favorability.

What is Sydecar doing to avoid PFIC investment issues?

At this time, Sydecar has made a policy to not support SPV investments into PFICs, but we are here to help you find the resources that can help with the PFIC rules. If you indicate the target company is a PFIC, it’s important to understand the IRS Form 8261 filing requirement.

Where can I go for more information?

When making investment decisions, venture investors typically focus on companies with high growth potential. However, some investors seek out tax-efficient investments that generate passive income outside the US. In 1986, in an attempt to close a loophole that created certain tax advantages, the IRS created a designation of passive income investments called PFICs, or Passive Foreign Investment Companies.

What are PFICs?

PFICs are non-U.S. based companies that either (i) generate 75% of gross income from “passive income” sources or (ii) use 50% of the company’s assets to generate “passive income.” Generally, passive income is income generated from sources that are not related to the company’s regular business operations. Principal forms of passive income as they relate to PFICs include interest, rents, royalties, capital gains, currency gains, and dividends. In general, most investors want to avoid PFICs because the IRS taxes gains from these investments at the ordinary income tax rate, as opposed to the lower capital gains tax rate.

How do PFICs apply to venture investments?

When investing outside of the US, VCs should be aware that some companies can inadvertently fall under the definition of a PFIC. Most commonly, PFIC designation may arise when an early-stage company is in a research and development stage and is therefore not generating any revenue from their regular business operations. For example, let’s say a company has raised millions from outside investors on a promising new product or service. The company generally will not spend all the money immediately, so excess cash is put into interest-bearing accounts until needed. Since the only income being generated is from interest on the deposits, this would fall into the first condition “generating 75% of gross income from passive income.” Further, it could fall into the second condition where 50% of the assets (most likely only cash raised) are generating passive income. Fortunately, the IRS has since created exceptions that help alleviate some of the traps that could catch non-US companies in PFIC classification.

What to look out for?

While it’s typically pretty easy to avoid PFIC restrictions when investing directly via an SPV or fund, an SPV investment into a fund (“fund of funds”) has the potential to trigger PFIC. SPVs are considered “look-through” vehicles for tax purposes, so it’s important to look at the underlying investment (especially if it is a foreign fund). If the company receiving the investment is a PFIC, investors must determine whether they are direct or indirect shareholders of the PFIC. In general, investors using Sydecar’s platform would not be “direct” shareholders of any PFIC since shareholders only own interests in SPVs. That said, a final determination is typically made by speaking directly with the company receiving investment.

How are PFICs treated for tax purposes?

If it is determined that an investment is a Passive Foreign Investment Company, there are three different ways a taxpayer can elect:

The Excess Distribution Regime: This is the default tax treatment and usually results in a larger tax burden. Generally, this election allows you to defer taxes (pay them later), but when taxes are due, they are very steep and include interest charges.
Qualified electing fund: A taxpayer must elect into this treatment. This method more closely follows US tax treatment of passive income with long-term capital gains retaining their favorable treatment. This is the most common PFIC election.
Mark to Market for Marketable Stocks: If a taxpayer’s holdings are regularly traded, they can elect this method. Basically, the taxpayer adds up all their gains and losses (realized & unrealized) each year and the result is taxed at higher ordinary income rates. Losses can only reduce gain to zero. This method is perhaps the most difficult to assess favorability.

What is Sydecar doing to avoid PFIC investment issues?

At this time, Sydecar has made a policy to not support SPV investments into PFICs, but we are here to help you find the resources that can help with the PFIC rules. If you indicate the target company is a PFIC, it’s important to understand the IRS Form 8261 filing requirement.