The PFIC Start-Up Exception: When a New Fund’s First Year Doesn’t Count

By Edward Parsons, CPA · licensed since 2009

Key takeaways

• Under section 1298(b)(2), a foreign corporation is not treated as a PFIC for its start-up year, the first taxable year it has gross income, when three conditions are met.
• The start-up year is the company’s first year with gross income, not the first year you held the shares.
• Two of the conditions look forward: the company must not be a PFIC in either of its next two taxable years. So the exception can’t be confirmed in the start-up year, and it can unwind after you file.
• A predecessor that was a PFIC rules the exception out. That matters for a fund formed by merger.
• If the exception fails, the start-up year is tested like any other. If the company was a PFIC that year, shares held then stay tainted.
• The PFIC Calculator & Form 8621 Generator applies the start-up year exception only when its conditions are met, and tests PFIC status every year on the company’s own fiscal year.

You got this far, so I’ll skip the basics. You know your fund is a PFIC. You know how the 125% test works, and you may have a spreadsheet that runs it block by block. That puts you ahead of most people who hold a foreign fund.

Here is what most calculations miss. They treat a new fund as a PFIC from its first day. The Code has an exception for a new company’s first year with income, and whether it applies isn’t settled until two more years have gone by.

What does the start-up exception say?

Section 1298(b)(2) says a corporation is not treated as a PFIC for “the first taxable year such corporation has gross income”. The Code calls that the start-up year. The exception applies only if all three of these hold:

• No predecessor of the corporation was a PFIC.
• It is established to the satisfaction of the Secretary that the corporation will not be a PFIC for either of the first two taxable years after the start-up year.
• The corporation in fact is not a PFIC for either of those two years.

A new company often looks passive before its business gets going. It holds the cash it raised, and interest is passive income under section 1297(b). Without the exception, it could fail the 75% income test in its first year on timing alone.

Be clear about who it helps. A fund that holds shares and bonds earns dividends, interest and gains, and those are passive income too. Most such funds will be PFICs in their second and third years as well, and then the third condition fails. The exception does its real work for a company that sat on cash before an operating business started earning.

Did you consider whose first year it is?

It’s the company’s first taxable year with gross income. It has nothing to do with when you bought.

If you bought in the fund’s fifth year, its start-up year was over before you arrived, and the exception doesn’t reach your shares. If you bought in its first year, it may decide whether those shares start clean.

The rule sets no minimum amount of gross income, so on its words a little interest on seed money before launch can make that the start-up year. And it is the company’s taxable year, which may not line up with yours, so it has to be mapped to your tax years.

Don’t confuse it with your own first year. The Form 8621 instructions say no part of a distribution in the first tax year of your holding period is an excess distribution. That is a rule about your block of shares, not about the company. My guide to the PFIC 125% test, block by block covers it.

Did you consider that it can unwind after you file?

The second and third conditions are about years that haven’t happened yet. When you file for the start-up year, you are filing on a forecast.

If either of those years turns out to be a PFIC year, the third condition fails and the exception never applied. A return you filed treating the start-up year as clean then rests on a fact that wasn’t true. My guide to catching up on Form 8621 reporting covers years that need revisiting.

The second condition has its own problem. The Code says the result must be “established to the satisfaction of the Secretary”, and it doesn’t say how. The final regulation next door, Treas. Reg. 1.1298-2, covers a different rule: the change-of-business exception in section 1298(b)(3), for a company whose passive income comes from selling its active businesses. It reads that rule’s forward-looking condition as the company reasonably not expecting to be a PFIC. I can’t find a regulation that does the same for the start-up year, or says whether that reading carries over.

The regulations on late QEF elections do anticipate a forecast like this. Treas. Reg. 1.1295-3 lets reasonable belief that a company isn’t a PFIC rest on predictions about later years, and lets a Protective Statement preserve a late QEF election. That is the QEF route, not section 1291. My comparison of QEF, mark-to-market and section 1291 sets the three side by side.

Did you consider the predecessor?

The first condition shuts the door if any predecessor was a PFIC. A fund formed by merging older funds together, or one that took over another fund’s assets, may have a predecessor. If that predecessor was a PFIC, the new fund gets no start-up year, however new it looks on paper.

The start-up rule itself doesn’t define “predecessor”. My guide to fund mergers, splits and spin-offs covers the events that create one.

Did you consider what failure costs?

If any condition fails, the start-up year is tested like any other year, on the income test and the 50% asset test. If the company passed either test that year, it was a PFIC.

That doesn’t stay in one year. Under the once a PFIC, always a PFIC rule of section 1298(b)(1), shares held while the company was a PFIC stay PFIC shares. It can even reach shares you no longer own. Buy in the start-up year and sell the next. If the year after that is a PFIC year, the exception fails, and if the company passed a test in the start-up year, the shares you sold were PFIC shares.

It changes the math too. Under section 1291, the part of an excess distribution allocated to years before the company was a PFIC is taxed as ordinary income in the current year. The part allocated to prior PFIC years carries deferred tax and interest. A failed exception can move the start-up year from the first group to the second.

Each purchase is its own lot, so a lot bought during the start-up year and a lot bought after it can sit in different positions. My guides to tainted and clean PFIC lots and why every purchase is its own calculation explain how one fund can carry both.

And it is not a filing exception. It asks whether the company is a PFIC, not whether you must file for one. That is a different list: see Form 8621 filing exceptions.

How the PFIC Calculator handles it

The PFIC Calculator & Form 8621 Generator tests PFIC status every year, on both tests, on the company’s own fiscal year mapped to your tax years. It applies the start-up year exception under section 1298(b)(2) only when its conditions are met. It keeps shares tainted in later years under the once-a-PFIC rule, and it separates tainted lots from clean ones, purchase by purchase.

What it won’t do matters as much. It flags what it can’t know instead of guessing, it refuses to guess a missing rate or price, and it computes section 1291 only, not QEF or mark-to-market.

One limit belongs to the rule, not to any tool: no start-up year answer is final until the next two years have been tested.

When to have a CPA look

If the start-up year decides whether a block is clean and the amounts are large, add the calculator’s optional CPA review: a CPA checks its workpapers before you file. It covers the calculator’s own workpapers only, not a return or forms prepared elsewhere.

The rest of the edge-case series

• PFIC Edge Cases: What Most Form 8621 Calculations Miss, the guide to the whole series
• 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 125% Test, Block by Block
• 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

• Start-up year: the first taxable year in which a corporation has gross income. Under section 1298(b)(2) it is not a PFIC year if all three conditions are met.
• Predecessor: an earlier entity whose PFIC status can carry into a later one, for example after a merger. A PFIC predecessor rules out the start-up exception.
• Tainted shares: shares held at any time while the company was a PFIC. They stay PFIC shares under section 1298(b)(1).
• Pre-PFIC year: a year in your holding period before the company became a PFIC. The excess allocated to it is taxed as ordinary income in the current year.
• Change-of-business exception: the neighbouring rule in section 1298(b)(3) for a company whose passive income comes from selling active businesses, with its own final regulation, Treas. Reg. 1.1298-2.
• PFIC: a passive foreign investment company. See what a PFIC is.

Frequently asked questions

What is the PFIC start-up exception?

Under section 1298(b)(2), a foreign corporation is not treated as a PFIC for its first taxable year with gross income if no predecessor was a PFIC, it is established to the satisfaction of the Secretary that it won’t be a PFIC in either of the next two taxable years, and it in fact isn’t.

Is the start-up year the first year I owned the shares?

No. It is the company’s first taxable year with gross income. If you bought after that year ended, the exception doesn’t reach your shares. Your own first year matters elsewhere: no part of a distribution in the first tax year of your holding period is an excess distribution.

Can the start-up exception be confirmed in the start-up year?

No. Two of its conditions are about the company’s next two taxable years, and one asks whether the company in fact was not a PFIC in them. That can’t be known until those years are over, so the exception can unwind after you file.

What happens if the start-up exception fails?

The start-up year is tested on the income and asset tests like any other year. If the company passed either test, it was a PFIC that year, and shares held then stay PFIC shares under the once-a-PFIC rule, including shares you have since sold.

Does the start-up exception apply to a fund formed by merger?

Not if a predecessor was a PFIC. The first condition rules the exception out in that case, however new the fund looks on paper.

Is the start-up exception a Form 8621 filing exception?

No. It asks whether the company is a PFIC at all. The filing exceptions ask whether you must file for a PFIC, and they are a separate list.

Check the first year before you trust it. Test the fund with the free PFIC Analyzer, then let the PFIC Calculator test every year, start-up year included.