Why the default PFIC tax is so harsh
With no election, a PFIC is a section 1291 fund. Nothing is taxed while you hold it, but when you sell, or receive an unusually large distribution, the gain is spread evenly over every day you owned the shares. The slice for the current year is ordinary income. Each slice for an earlier PFIC year is taxed at the highest rate in effect for that year, whatever your actual bracket was, plus an interest charge as if that tax had been paid late. Gains never qualify for capital gains rates. Our Form 8621 explainer covers the default rules and the filing requirements in full.
The point of both elections is the same: pay tax every year as you go, so there is nothing to spread back and nothing to charge interest on.
Option 1: the QEF election (section 1295)
How it taxes you
If you treat the PFIC as a qualified electing fund (QEF), each year you include your pro rata share of two amounts, whether or not the fund pays anything out:
- the fund's ordinary earnings, taxed as ordinary income; and
- the fund's net capital gain, taxed as long-term capital gain.
Ordinary earnings are the fund's earnings and profits for the year minus its net capital gain, and the net capital gain inclusion cannot exceed earnings and profits. Your share is worked out as if the fund distributed its earnings evenly over each day of its year.
Your basis in the shares goes up by what you include. When the fund later distributes those already-taxed earnings, you are not taxed again and your basis goes down. When you sell, the gain or loss is measured against that adjusted basis and is a capital gain or loss.
Three details matter in practice:
- Losses do not pass through. You include the fund's ordinary earnings and net capital gain, both capped by its earnings and profits. In a loss year there is nothing to include, but you cannot deduct the fund's loss either. It only shows up indirectly, in a lower sale price.
- No qualified dividend rate. A PFIC is not a qualified foreign corporation, so ordinary earnings are taxed at ordinary rates, not the lower dividend rate.
- You can defer tax on undistributed earnings, at a cost. Election B on Form 8621 (section 1294) lets you postpone paying the tax on earnings the fund has not distributed, but interest runs on the deferred tax until the election ends.
What you need to make it
The fund's cooperation. You can only report QEF income if the PFIC gives you a PFIC Annual Information Statement, signed by the fund or its representative. It must give the fund's tax year and either your share of ordinary earnings and net capital gain, enough information for you to calculate them, or confirmation that you were allowed to examine the fund's books. It must also show what was distributed, and include the fund's promise to let you inspect and copy its records. If the fund will not provide one, QEF is not available.
A timely election. You make Election A on Form 8621, filed by the due date, including extensions, of your return for the first year you want it to apply. If you make it for the first year the company is a PFIC while you hold the shares, the fund is a pedigreed QEF for you: a QEF for every year of your holding period in which it was a PFIC.
The right person to elect. The election belongs to the US person that is the shareholder. If a domestic partnership or S corporation holds the PFIC, the entity makes the election, not its partners or shareholders. For a consolidated group, the common parent elects for all members. A separate election is needed for each PFIC.
Once made, the election applies to that year and every later year. Revoking it needs IRS consent, after a substantial change in circumstances.
Option 2: the mark-to-market election (section 1296)
How it taxes you
With a mark-to-market election, at the end of each year you compare the shares' fair market value with your adjusted basis:
- If the value is higher, you include the difference as ordinary income, and your basis goes up by the same amount.
- If the value is lower, you can deduct the decline as an ordinary loss, but only up to your unreversed inclusions: the mark-to-market income you have included in earlier years, less any mark-to-market deductions already taken. Your basis goes down by what you deduct.
When you sell, gain is ordinary income. A loss is ordinary up to your unreversed inclusions, and any loss beyond that is treated under the normal rules, typically as a capital loss.
So mark-to-market removes the interest charge and the top-rate allocation, but it never gives you capital gains rates on the fund's growth.
What you need to make it
Marketable stock. The shares must be regularly traded on a qualified exchange or market, which means traded in more than minimal amounts on at least 15 days in every calendar quarter. Qualified markets are SEC-registered US exchanges, the national market system, and foreign exchanges that are government-regulated and meet volume, listing, disclosure and surveillance standards. Options on marketable stock also qualify.
There is a narrow extra route for open-ended foreign funds whose shares are redeemable at net asset value. For the class you hold, the fund must at all times during the year have more than 100 unrelated shareholders, be open to the general public with a minimum investment of no more than $10,000, publish its price at least weekly in a medium it does not control, have independently audited annual accounts, be regulated as an investment company, have no senior securities beyond minimal debt, and earn and hold at least 90% passive income and assets. A typical private fund meets few of these tests.
A timely election. You make Election C on Form 8621 by the due date, including extensions, of your return for the year. Late elections need relief under the general extension rules.
The election applies to that year and every later year. It ends automatically if the shares stop being marketable. Otherwise, revoking it needs IRS consent. It even stays in force if the company stops being a PFIC, so later PFIC years are still marked to market.
Side by side
| QEF (§1295) | Mark-to-market (§1296) | No election (§1291) | |
|---|---|---|---|
| Needs | PFIC Annual Information Statement from the fund | Shares regularly traded on a qualified market, or a qualifying NAV fund | Nothing |
| Taxed when | Every year, on the fund's earnings | Every year, on the rise in share price | On large distributions and on sale |
| Character | Ordinary earnings: ordinary. Net capital gain: long-term capital gain | Ordinary income | Ordinary income, earlier years at the top rate |
| Interest charge | Only if you defer under Election B | None, except in the first election year if the election was late | Yes, on tax allocated to earlier years |
| Losses | Not passed through; reflected in basis on sale | Deductible only up to unreversed inclusions | The excess distribution rules apply to gains only |
| Form 8621 | Election A, Part III | Election C, Part IV | Part V |
Worked example
An investor in the top bracket buys $100,000 of shares in a foreign fund on 1 January 2022 and sells them on 31 December 2026 for $150,000. The fund is a PFIC throughout. It pays no distributions, and its value rises by $10,000 a year. To keep the numbers simple, assume the fund realises all its gains each year, so every year it earns $4,000 of interest and dividends (ordinary earnings) and $6,000 of net capital gain. Rates are the 2022 to 2026 federal rates: 37% top ordinary rate and 20% long-term capital gains rate. The example ignores the 3.8% net investment income tax and state tax.
- QEF from day one. Each year the investor includes $4,000 of ordinary income and $6,000 of long-term capital gain, and basis rises by $10,000 a year to $150,000. The sale at $150,000 produces no further gain. Over five years: $20,000 taxed at 37% ($7,400) plus $30,000 at 20% ($6,000), so $13,400, paid year by year.
- Mark-to-market from day one (if the shares were listed). Each year the $10,000 rise is ordinary income, and basis climbs to $150,000, so the sale adds nothing. Over five years: $50,000 at 37%, so $18,500, paid year by year.
- No election. Nothing is taxed until the sale. Then the whole $50,000 gain is spread evenly over the 1,826 days of the holding period, about $10,000 a year. The 2026 slice is ordinary income: about $3,700 of tax. The 2022 to 2025 slices are taxed at each year's top rate of 37%: about $14,800. The total is about $18,500 plus interest on the $14,800, charged from each earlier year's return due date.
The lesson: in this example the default tax matches mark-to-market before interest, and the interest charge is what makes it worse. QEF saves real money because $30,000 of the growth is taxed as capital gain. With a fund that earns mostly interest, as many credit funds do, the QEF advantage shrinks, because most of its earnings are ordinary anyway.
If you missed the first year
Elections made after the first year of your holding period do not wipe out the past on their own.
- A late QEF election leaves the earlier years under section 1291, making the fund an unpedigreed QEF. You can purge them with a deemed sale election (Election D): you are treated as selling the shares on the first day of the fund's first QEF year, any gain is taxed as an excess distribution with interest, and a loss is not recognised. If the PFIC is also a controlled foreign corporation, you can instead make a deemed dividend election (Election E) and pay the default tax on your share of the earnings it built up while a PFIC. Either way, you pay the price of the past once and start clean.
- A late mark-to-market election applies section 1291 one last time: at the end of the first election year, the shares' whole built-in gain (value over basis) is treated as gain from a sale and taxed under the default rules, with interest. From the next year on, the normal mark-to-market rules apply.
- A retroactive QEF election is possible in limited cases: if you filed a protective statement on time because you reasonably believed the company was not a PFIC; if you own less than 2% of the company and its public filings said it reasonably believed it was not a PFIC; or with IRS consent, which requires showing you reasonably relied on a qualified tax professional, a closing agreement if the delay lowered your tax, and a request made before the IRS raises the issue on audit.
Which one to pick
- The fund provides an Annual Information Statement: make a QEF election in your first year. It is the only route to capital gains rates.
- No statement, but the shares are listed and regularly traded: mark-to-market is the fallback. You pay ordinary rates, but you avoid the interest charge and top-rate allocation.
- Neither is available: you are in the default regime. Keep records of every purchase, distribution and holding period, because the calculation on exit depends on them.
- You are already past year one: decide whether paying the purge now is cheaper than the default tax later. For a holding you plan to keep for years, it usually is.
What it means for fund investors
PFIC exposure is common across private funds. Offshore feeder funds organised as corporations, foreign holding companies and non-US listed real estate or infrastructure vehicles can all be PFICs for a US taxable investor. Because these interests are rarely traded on an exchange and seldom meet the NAV fund tests, mark-to-market is usually unavailable, which makes the Annual Information Statement the key document. Some sponsors that market offshore vehicles to US taxable investors commit to providing one, so check the offering documents and ask before you invest.
If you invest through a US fund partnership, the partnership, not you, makes the QEF election for the PFICs it holds, so the decision sits with the fund's tax team. And for a 10% or more US shareholder of a company that is also a CFC, the CFC rules (subpart F and NCTI, formerly GILTI) generally take over and the PFIC rules do not apply to that stock.
This explainer is general information, not tax advice.
Sources
- 26 U.S. Code § 1293, Cornell LII
- 26 CFR § 1.1295-1, Cornell LII
- 26 CFR § 1.1295-3, Cornell LII
- 26 CFR § 1.1296-1, Cornell LII
- 26 CFR § 1.1296-2, Cornell LII
- 26 CFR § 1.1291-9, Cornell LII
- Instructions for Form 8621 (12/2025), IRS
Related reading
- Form 8621 and PFIC Reporting Explained
- Form 5471 Filer Categories Explained
- Glossary: PFIC (passive foreign investment company)
This explainer is analysis and general information, not tax, legal or investment advice.