Tainted and Clean PFIC Lots: One Fund, Two Tax Treatments

By Edward Parsons, CPA · licensed since 2009

Key takeaways

• Section 1298(b)(1) tests each lot over its own holding period, so one fund can carry tainted and clean lots at once.
• A lot held on even one day of a PFIC year stays tainted after the fund stops qualifying. Its whole gain is still taxed under section 1291.
• The years after the fund stopped qualifying still carry top-rate tax and interest on that gain.
• A purging election cleans every lot you held on the fund’s last PFIC day, all at once. Gains are taxed now. Losses are not recognized.
• The PFIC Calculator & Form 8621 Generator separates tainted lots from clean ones and keeps the taint in later years.

You got this far. You know your fund is a PFIC, you know the income and asset tests and the 125% test, and you may have a spreadsheet that spreads a gain across your holding period. You know the once a PFIC, always a PFIC rule too: a fund that stops qualifying doesn’t take your shares with it.

Good. Here is what most calculations miss. That rule runs per lot, not per fund.

Why can one fund hold tainted and clean lots?

Because the test looks at each lot’s own holding period.

Section 1298(b)(1) treats stock as PFIC stock if the company was a PFIC, and not a qualified electing fund, at any time during your holding period “with respect to such stock.” Not whether the fund was ever a PFIC. Whether it was one while you held these shares.

Take a fund that was a PFIC for some years and then passed neither test.

• A lot bought while it was a PFIC is tainted.
• A lot bought earlier, and still held when it qualified, is tainted from then on.
• A lot bought after its last PFIC year, and never held through another, is clean.

The line falls on the fund’s year end, not yours. PFIC status is decided for the company’s taxable year under section 1297(a). A lot bought on the last day of a PFIC year is tainted. A lot bought the next morning can be clean. You won’t know which side a purchase landed on until that year closes and the fund’s figures are out.

What happens when you sell a tainted lot in a clean year?

Section 1291 applies as if nothing had changed. Line 15f of Form 8621 even asks for gain or loss from a “section 1291 fund or former section 1291 fund.” Under section 1291(a)(2), the whole gain on the lot is an excess distribution, spread evenly over every day you held it.

Here is the part people miss. Only the current year’s slice, and the slice for days before the fund’s first PFIC year, are ordinary income. Every other year is taxed at its own highest rate, with interest. Line 16c of the Form 8621 instructions carves out only the current year and pre-PFIC years, and the years after the fund stopped qualifying aren’t pre-PFIC years. They sit in the expensive bucket.

Sell a clean lot of the same fund in the same trade and it is outside section 1291 altogether. One fund, one price, two tax treatments, and only the tainted lot goes on Part V.

Can a purging election clean a tainted lot?

Yes, at a price, and on terms most people don’t expect.

Once the fund stops qualifying, section 1298(b)(1) and Treas. Reg. §1.1298-3 allow a deemed sale election. You are treated as selling all your stock in the former PFIC at fair market value on the last day of its last PFIC year, the termination date. Lot by lot:

• Every lot you held that day goes in. You can’t purge only the cheap ones.
• Gains are taxed under section 1291 as an excess distribution on the termination date, with interest.
• Losses are not recognized. A lot under water gets no basis adjustment and doesn’t soften the gain on the others.
• The PFIC clock restarts the next day for every lot covered, gain or loss, but only for the PFIC rules.

The termination date is the fund’s year end, so you need a value on a date that may not be yours. The election goes with your original return for the year that includes that date, or an amended one filed within three years of its extended due date. After that, the only route is a late election on Form 8621-A, which needs IRS consent, a closing agreement and a request made before the IRS raises the fund’s PFIC status on audit. If years have gone unfiled, see catching up on Form 8621. The deemed dividend version needs the fund to have been a controlled foreign corporation in its last PFIC year.

Does a QEF election from the first year avoid the taint?

Yes. Section 1298(b)(1) only reaches years the fund was not a qualified electing fund, and section 1291 doesn’t apply if it was a QEF for every PFIC year you held it. That is a pedigreed QEF. A later QEF leaves the earlier years under section 1291 unless you purge them. My guide to QEF, mark-to-market and the default method compares the three.

Did you consider which lot your sale hit?

If you didn’t name the lot when you sold, you can’t pick it now. Treas. Reg. §1.1012-1(c) charges unidentified shares to your earliest lot, for basis and holding period. At a broker, identifying means telling the broker at the time of sale and getting written confirmation. In a fund that stopped qualifying, the earliest lots are usually the tainted ones, so FIFO tends to sell them first. See PFIC lot tracking and FIFO.

Did you consider whether the first year counted?

A lot is only tainted by a year the fund actually was a PFIC. Under section 1298(b)(2), a new company’s first year with gross income doesn’t count if its conditions are met, including that no predecessor was a PFIC and that it isn’t one in either of the next two years. So whether your earliest lots are tainted can depend on what the fund does two years later. See the PFIC start-up exception.

Did you consider what a merger carried across?

Section 1298(b)(1) covers the company “or any predecessor.” In a tax-free exchange, section 1223(1) generally adds the old shares’ holding period to the new ones, PFIC days included. A fund that looks clean can hold lots tainted before it existed. Section 1291(f) leaves to regulations whether the exchange is itself a taxable disposition of PFIC stock, and none have been finalized. See fund mergers, splits and spin-offs.

Did you consider a loss on a tainted lot?

A loss on a tainted lot isn’t taken into account under section 1291. The Form 8621 instructions say it doesn’t reduce the gain subject to section 1291, and the form puts it in brackets with no line 16. A sale that hits a tainted winner and a tainted loser is taxed on the winner as if the loser weren’t there, though the loss may count under other rules. See why a loss on one block doesn’t offset a gain on another. Buy back inside the wash sale window and sections 1091(d) and 1223(3) move the disallowed loss and the old holding period into the new lot, PFIC days and all. See wash sales and PFIC shares.

How the PFIC Calculator handles it

The PFIC Calculator & Form 8621 Generator treats each purchase as its own lot and separates tainted lots from clean ones: a lot is tainted if the fund was a PFIC for even one day you held it. It tests PFIC status every year on the fund’s own fiscal year, mapped to your tax years, and keeps shares tainted after the fund stops passing the tests. It applies the start-up exception only when its conditions are met, matches sales lot by lot, and says so when it has to assume FIFO. It carries basis and holding periods lot by lot through mergers. A loss shows in brackets and never offsets a gain on another block. Every figure is in the workpapers.

It computes section 1291 only: no QEF, no mark-to-market, no purging election. And it won’t guess a missing rate or price. It flags the gap.

When to have a CPA look

If the fund changed status while you held it, or you are weighing a purge, the arithmetic is the easy part. The calculator offers an optional CPA review of its own workpapers before you file. It covers what the calculator produced, not a return or forms prepared somewhere else.

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
• 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

• Lot: shares bought on the same day, which share a holding period. Also called a block.
• Tainted lot: a lot held at any time while the fund was a PFIC and not a QEF. Section 1298(b)(1) keeps it PFIC stock for as long as you hold it.
• Clean lot: a lot never held during a PFIC year of the fund, or of any predecessor.
• Former PFIC: a fund that now passes neither the income test nor the asset test, but whose shares stay PFIC stock in your hands because of an earlier PFIC year.
• Termination date: the last day of the fund’s last taxable year as a PFIC. A purging election treats your shares as sold on that date.
• Pre-PFIC days: days in your holding period before the fund’s first PFIC year. Gain allocated to them is ordinary income in the current year. See what a PFIC is.

Frequently asked questions

Can the same PFIC have tainted and clean shares?

Yes. Section 1298(b)(1) asks whether the fund was a PFIC at any time during your holding period for that stock. Lots bought after the fund’s last PFIC year, and never held through another one, are clean. Lots held through a PFIC year are tainted.

If my fund is no longer a PFIC, is my gain still taxed under section 1291?

For a tainted lot, yes. The whole gain is treated as an excess distribution and spread over the lot’s holding period. Only the current year and pre-PFIC days are ordinary income. The rest is taxed at each year’s top rate with interest, including the years after the fund stopped qualifying.

What does a PFIC purging election cost?

Under the deemed sale election in Treas. Reg. §1.1298-3, you are treated as selling all your shares at fair market value on the fund’s last PFIC day. The gain is taxed under section 1291 with interest. Losses are not recognized and get no basis adjustment.

Can I purge only some of my lots?

No. The deemed sale election treats you as selling all your stock in the former PFIC on the termination date. Every lot held that day is covered, winners and losers alike.

Can I choose to sell my clean lots first?

Only if you identified them to your broker at the time of sale and got written confirmation. Otherwise Treas. Reg. §1.1012-1(c) charges the sale to your earliest lot, which in a fund that stopped qualifying is usually a tainted one.

Does the PFIC Calculator compute a purging election?

No. It computes section 1291 only. It separates tainted lots from clean ones and keeps the taint in later years, but it doesn’t compute QEF, mark-to-market or purging elections.

See which of your lots carry the taint. Load your transactions into the PFIC Calculator and let it separate tainted lots from clean ones before the next sale goes on a form.