The PFIC 125% Test, Block by Block

By Edward Parsons, CPA · licensed since 2009

Key takeaways

• An excess distribution is the part of a year’s distributions above 125% of the average you received in the 3 prior years, or in the shorter part of your holding period before the year.
• The test runs share by share. Only shares with the same holding period may be grouped, so every purchase and every reinvested dividend is its own block.
• A block has no excess distribution in the year its holding period begins.
• An earlier excess distribution counts in the base only to the extent it was included in income. The part that went to prior PFIC years drops out.
• Part years are annualized, splits and stock dividends need adjusting, and distributions paid in a single foreign currency are tested in that currency.
• The PFIC Calculator & Form 8621 Generator runs the test for every block and shows the base behind each figure.

You got this far. You know the fund is a PFIC and no election is in place, so section 1291 applies. You know the 125% test: this year’s distributions against 125% of the average for the three years before. Maybe you’ve already built the spreadsheet. Good. Most people never get that far.

Here is what most calculations miss. The test doesn’t run on the fund. It runs on blocks of shares, and each block carries its own history.

What does the 125% test actually compare?

What one block received this year, against what that same block received before.

Section 1291(b) defines the total excess distribution as the distributions you received on the stock during the year, over 125% of the average amount you received on that stock in the 3 preceding years. If your holding period before the year is shorter than that, the average uses the shorter period. Each distribution in the year then takes its ratable share of the total.

Then section 1291(b)(3) lists adjustments, left to regulations: share-by-share testing, splits and stock dividends, part years and foreign currency. Each is a place where a fund-level spreadsheet quietly goes wrong. A fund-wide average blends blocks with different histories, and the blend moves the threshold for all of them.

Did you consider that every reinvested dividend starts a new block?

It does, and each new block gets its own first year.

The Form 8621 instructions say to complete lines 15a to 15e separately for each block of shares with the same holding period. A reinvested distribution buys shares with a new holding period. Reinvest every quarter and you add four blocks a year.

Section 1291(b)(2)(B) sets the total excess distribution to zero for the year in which your holding period in the stock begins. So every new block skips the test in its first year. The year after, its base is short, and the instructions divide by the number of prior years in your holding period when that is fewer than three. A block with a short base can show an excess on a distribution that looks ordinary at fund level.

A block doesn’t always begin on its purchase date, either. Section 1291(a)(3)(A) takes the holding period from section 1223, and shares bought in a wash sale take on the holding period of the shares sold. That can move a block’s first year back.

My guide to PFIC lot tracking covers why each purchase is its own calculation, and wash sales and PFIC shares covers the holding period that moves.

Did you consider what an earlier excess distribution does to the base?

It stays in the base only in part, and most spreadsheets get this wrong one way or the other.

The sentence that closes section 1291(b)(2)(A) says an excess distribution received during the 3-year period is taken into account “only to the extent it was included in gross income under subsection (a)(1)(B).” Line 15b of Form 8621 says the same.

What section 1291(a)(1)(B) includes in income is the share of that earlier excess allocated to its own year and to any pre-PFIC days. The share allocated to prior PFIC years went into the deferred tax instead. That share drops out of the base.

So there are two easy errors. Leave the whole earlier distribution in, and the base is too high, so this year’s excess comes out too small. Take it all out, and the base is too low. Either error repeats for every year that earlier distribution sits in the 3-year window.

And the right figure depends on how that earlier excess was spread across your holding period at the time. The 125% test in one year leans on the allocation of another.

Did you consider part years and splits?

Both change the base, and the statute names both.

Section 1291(b)(3)(C) says that if you don’t hold the stock during the entire taxable year, the distributions received during that year are annualized. Part years sit at both ends of a block’s life: the year you buy and the year you sell. The statute doesn’t say how to annualize, and there are no final regulations that do.

Section 1291(b)(3)(B) requires proper adjustments for stock splits and stock dividends. A history kept per share breaks the day the share count changes. Without the adjustment, the base and the current year measure different things. Splits, reverse splits and mergers are covered in my guide to PFIC events that don’t look like sales.

Did you consider the currency, and the years the fund wasn’t a PFIC?

Section 1291(b)(3)(E) says that when distributions are received in a foreign currency, the determination is made in that currency, and only the excess is translated into dollars. Test in dollars when every distribution came in one foreign currency, and an exchange rate move can look like a rise in distributions. The Form 8621 instructions set out when each currency applies, and my guide to PFIC currency translation works through them.

Then there is the question that comes before the test. The base is what you received on the stock in the 3 prior years, and the definition doesn’t ask whether the fund was a PFIC in each of them. But whether a block is PFIC stock at all depends on the fund’s status during that block’s holding period, under section 1298(b)(1). A block never held while the fund was a PFIC may need no test at all. See tainted and clean PFIC lots and the start-up exception for those years.

What happens to the excess next?

It is allocated to each day of the block’s holding period. Part becomes ordinary income this year, and the rest is taxed at each prior year’s top rate, with interest. That has its own traps, covered in the PFIC interest charge. For the regime as a whole, see the PFIC excess distribution regime.

How the PFIC Calculator handles it

The PFIC Calculator & Form 8621 Generator runs the 125% test per block of shares. It annualizes part years, gives a block no excess in its first holding year, and adjusts the base for earlier excess distributions. It runs the test in the fund’s own currency and translates only the excess. Each purchase is its own lot, splits and reverse splits are carried through, and each block of shares gets its own Part V, as the Form 8621 instructions describe. You can see every figure behind the form and export it.

What it won’t do: guess. Shares transferred in with no acquisition date, or a distribution on a date when no shares were held, are flagged for you instead of filled in. And it computes the default method under section 1291 only, not QEF or mark-to-market.

When to have a CPA look

If you hold many blocks, or an earlier excess distribution or a split sits inside the 3-year window, consider the optional CPA review. You send the calculator’s workpapers for review, your figures are frozen while they’re checked, and a CPA reviews them before you file. It covers the workpapers the calculator produced. It isn’t a review of a return or forms prepared somewhere else. The details are in the calculator’s pricing section.

The rest of the edge-case series

• PFIC Edge Cases: What Most Form 8621 Calculations Miss
• The PFIC Start-Up Exception: When a New Fund’s First Year Doesn’t Count
• Tainted and Clean PFIC Lots: One Fund, Two Tax Treatments
• PFIC Lot Tracking: Why Every Purchase Is Its Own Calculation
• Wash Sales and PFIC Shares: The Loss and Holding Period That Move
• Fund Mergers, Splits and Spin-Offs: PFIC Events That Don’t Look Like Sales
• ISIN, Listing or Charter: What Makes a Fund Foreign for PFIC Purposes
• The PFIC Interest Charge: Daily Allocation, Top Rates, Daily Compounding
• PFIC Losses: Why a Loss on One Block Doesn’t Offset a Gain on Another
• PFIC Currency Translation: Spot Rates, Fund-Currency Math and Pence
• Form 8621 Filing Exceptions: Every One, and Where Each Stops

Glossary

• Total excess distribution: the year’s distributions on a block, over 125% of the average received on it in the 3 prior years or the shorter holding period before the year.
• Excess distribution: each actual distribution’s ratable share of the total excess distribution. A gain on sale is treated as one too.
• Block of shares: shares with the same holding period, which may be tested together. Each purchase and each reinvested dividend starts one.
• Base: the prior-year average the 125% test compares against, after the adjustments in section 1291(b)(3).
• Nonexcess distribution: the part of a distribution that isn’t excess, taxed under the ordinary dividend rules.
• PFIC: a passive foreign investment company, including most foreign mutual funds and ETFs. See what a PFIC is.

Frequently asked questions

What is the PFIC 125% test?

It measures whether a distribution is an excess distribution. Under section 1291(b), the excess is the part of a year’s distributions on a block of shares above 125% of the average received on that block in the 3 prior years, or the shorter part of the holding period before the year.

Is there an excess distribution in the first year I own PFIC shares?

No. Section 1291(b)(2)(B) sets the total excess distribution to zero for the year your holding period in the shares begins. That applies block by block, so every new purchase and every reinvested dividend gets its own first year.

Do I run the 125% test for the whole fund or for each purchase?

For each block. The statute makes the determination share by share and allows grouping only of shares with the same holding period. The Form 8621 instructions ask for lines 15a to 15e separately for each such block.

Do earlier excess distributions count in the three-year average?

Only in part. Section 1291(b)(2)(A) takes an earlier excess distribution into account only to the extent it was included in gross income under section 1291(a)(1)(B), meaning the share allocated to its own year and any pre-PFIC days. The share that went to prior PFIC years drops out.

What if I held the shares for only part of a year?

Section 1291(b)(3)(C) says the distributions for that year are annualized. The statute doesn’t say how, and there are no final regulations that do.

Run the 125% test on every block, not the fund. Load your history into the PFIC Calculator and see the base behind each excess distribution.