IRC 1296: Mark-to-Market Election for PFIC Stock

Internal Revenue Code (IRC) Section 1296 provides a specific tax mechanism, the mark-to-market election, for U.S. persons holding stock in a Passive Foreign Investment Company (PFIC). This election offers an alternative to the default tax rules that often apply to such investments. This approach requires the shareholder to recognize changes in the investment’s value each year, regardless of whether any shares have been sold.

The mark-to-market election alters the timing and character of the income or loss recognized from the PFIC investment. It is a voluntary choice that must be proactively made by the taxpayer to apply to their marketable PFIC stock.

The Passive Foreign Investment Company (PFIC) Framework

A foreign corporation is designated a Passive Foreign Investment Company (PFIC) if it meets specific financial criteria. The first is an income test, which is met if 75% or more of the corporation’s gross income for the taxable year is passive income, such as dividends, interest, rents, and royalties. The second criterion is an asset test, which is met if at least 50% of the average value of its assets held during the year are assets that produce, or are held to produce, passive income.

For publicly traded corporations, the asset test is generally based on the fair market value of the assets. Without a specific election, U.S. shareholders of a PFIC are subject to a default tax regime under IRC Section 1291. This system targets “excess distributions,” which are either gains from selling PFIC stock or actual distributions that exceed 125% of the average distributions from the prior three years. These amounts are not treated as typical capital gains or dividends.

The tax treatment for excess distributions allocates the gain or distribution over the shareholder’s entire holding period for the stock. The portion allocated to the current tax year is taxed as ordinary income. The portions allocated to prior years are taxed at the highest ordinary income tax rate for those years, plus an interest charge, which eliminates the benefits of tax deferral and preferential capital gains rates.

How the Mark-to-Market Election Works

The mark-to-market election is only available for “marketable stock.” This term refers to PFIC stock that is regularly traded on a qualified securities exchange, such as major national exchanges registered with the U.S. Securities and Exchange Commission (SEC) or certain foreign exchanges.

Under the mark-to-market election, a shareholder treats their PFIC stock as if it were sold at its fair market value (FMV) on the last day of the tax year. If the year-end FMV is greater than the shareholder’s adjusted basis in the stock, the excess is included in the shareholder’s gross income as ordinary income. This gain is not eligible for lower capital gains tax rates.

Conversely, if the shareholder’s adjusted basis in the stock is greater than its year-end FMV, the shareholder may be able to take a deduction. This deduction is treated as an ordinary loss, but it is limited to the amount of “unreversed inclusions.” This means a loss can only be deducted to the extent that the shareholder has previously included net mark-to-market gains from that same PFIC stock in prior years.

The shareholder’s adjusted basis in the PFIC stock is adjusted annually to reflect the recognized gains or losses. The basis is increased by the amount of gain included in income and decreased by the amount of any loss deducted. For example, if a taxpayer buys PFIC stock for $1,000 and at the end of Year 1 its FMV is $1,200, the taxpayer reports $200 of ordinary income and their basis becomes $1,200. If at the end of Year 2 the FMV is $900, they can deduct a $200 ordinary loss, limited to the previously included gain, and the basis is then reduced to $1,000.

Required Information and Form 8621 Preparation

To prepare for the mark-to-market election, a taxpayer must gather specific financial documents. The primary information needed includes year-end brokerage statements to establish the fair market value (FMV) of the PFIC stock. The taxpayer also needs to know their adjusted basis in the stock at the beginning of the tax year, the name of the PFIC, and a description of each class of shares held.

The required reporting is done on Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.” A separate Form 8621 must generally be filed for each PFIC in which the taxpayer invests. When completing the form, the taxpayer starts with general information, which requires the PFIC’s name and a description of the shareholder’s stock.

The core of the mark-to-market reporting occurs in Part IV, “Mark-to-Market Election.” Here, the taxpayer enters the stock’s FMV at year-end and its adjusted basis to calculate the gain or loss. The calculated gain is reported as ordinary income on the taxpayer’s main tax return, such as Form 1040. If there is a loss, the taxpayer must determine the amount of their “unreversed inclusions” from prior years to correctly apply the loss limitation.

Filing and Maintaining the Election

After completing Form 8621, the shareholder must attach it to their annual income tax return, such as Form 1040, for the year the election is being made. The election is not filed separately; it becomes an integral part of the taxpayer’s overall return.

The mark-to-market election must be made by the due date, including any extensions, of the income tax return for the first year the election is intended to be effective. For example, to have the election apply to the 2024 tax year, the Form 8621 making the election must be filed with the 2024 tax return by its deadline in 2025. A failure to file on time can prevent the use of this election for that year.

Once made, the election is binding for all subsequent tax years in which the taxpayer holds the stock and the foreign company continues to qualify as a PFIC. The shareholder must continue to file Form 8621 annually, reporting the mark-to-market gain or loss each year. Revoking a mark-to-market election requires consent from the IRS, which may be granted if there is a substantial change in circumstances, but this is not guaranteed.