The Internal Revenue Service does not impose penalties for failing to identify a PFIC per se.

But if the taxpayer’s failure results in an underreporting of income and a failure to pay tax, the IRS will demand payment plus interest and penalties.

### Higher tax rates …

The biggest problem with failing to identify a PFIC is that one likely will have to pay a higher rate of tax. For example, a capital gain taxed at the long-term capital gains tax rate could be taxed instead at the much tax rate for ordinary income.

Let us walk through a hypothetical scenario. A person invests $50,000 in a passive foreign investment company at the beginning of Year 1. The person does not know that he has invested in a passive foreign investment company.

Over the next three years, the value of the passive foreign investment company increases to $125,000. The investor sells for a profit of $75,000. On his tax return, he reports the $75,000 as a long-term capital gain. With an income of $190,000 the taxpayer’s long-term capital gains tax rate is 15%.

Tax on the capital gain = $75,000 x 15% = $11,250

Three years later the IRS has determined that the investment was a passive foreign investment company. Under the default method of PFIC taxation, the IRS taxes the gain at the taxpayer’s ordinary income tax rate, in this case 28%.

Revised tax on the capital gain = $75,000 x 28% = $21,000

Underpayment of tax = $21,000 – $11,250 = $9,750

### Penalties and interest …

The calculation of interest and penalties can be complex. Let’s come up with a simple analysis.

Let’s assume that the penalty is 0.5% per month.

Penalty = 36 months x 0.5% x $9,750 = $1,755

Let’s assume an interest rate of 3%.

Interest = 3 years x 3% x $9,750 = $877.50

Total cost = $23,632.50 of which $11,250 has been paid.

The total cost, as a percentage of the capital gain = $23,632.50 ÷ $75,000 = 31.5%

Fortunately, interest rates today are low and thus the interest charges do not amount to much. In the past, we have seen much higher rates of interest. If the interest rate had been 8%, the math would have been different:

Interest = 3 years x 8% x $9,750 = $2,340

Total cost = $25,095 of which $11,250 has been paid.

The total cost, as a percentage of the capital gain = $25,095 ÷ $75,000 = 33.5%

None of this legal advice. See the Terms of Service.