Many U.S. expats buy foreign mutual funds or other foreign investments without realizing the IRS treats them as passive foreign investment companies (PFICs).
This article explains how the excess distribution rules work, how the tax is calculated, and why it often leads to unexpectedly high U.S. taxes for expats
To understand the foundation of PFIC taxation, here’s our article that lays it out: PFIC rules
Key Takeaways for US Expats
- Foreign mutual funds are almost always PFICs.
- Under the default PFIC rules, an excess distribution can trigger huge back-tax bills.
- The IRS doesn’t tax you annually unless you elect QEF or mark-to-market.
- With no election, the IRS “recreates” past years, taxing at the highest ordinary income rate + interest charges.
- Elections shift you to annual taxation, which can significantly reduce your long-term tax burden.
- Always file Form 8621 to stay compliant with U.S. reporting requirements.
What is an Excess Distribution under PFIC rules?
An excess distribution occurs when the payout from a PFIC in a given tax year is more than the IRS allows under its PFIC rules. To calculate it, the IRS takes the average distributions received during the prior three years (or your full shareholder’s holding period if shorter). If the current year’s payout is greater than 125% of that average, the excess is treated as an excess distribution.
Example: If your average distributions were $1,000 and you receive $5,000 from foreign mutual funds, the first $1,250 is considered ordinary. The remaining $3,750 is the excess distribution, which under PFIC taxation rules becomes distribution allocated across prior years, creating deferred tax, interest charges, and a much higher tax liability.
How is an Excess Distribution Taxed?
Under the default PFIC provisions, excess distributions are not taxed like normal capital gains. Instead:
- The distribution allocated to the current year is taxed as ordinary income.
- The portions allocated to prior years are taxed at the highest ordinary income rates in effect for those years.
- An interest charge is added to the deferred tax as if it should have been paid back then.
This system means the longer you hold PFIC shares, the larger the tax consequences when an excess distribution or sale happens.
That’s why the rules feel unfair: the IRS is “catching up” on all the untaxed growth by pretending you should have paid in earlier years.
Worked Example: Default PFIC Rules
Assume you bought mutual funds abroad in 2022 and held them until 2025.
- 2022–2024: average distributions = $1,000
- 2025: payout = $5,000
Step 1 – Threshold: $1,000 × 125% = $1,250
Step 2 – Excess Distribution: $5,000 − $1,250 = $3,750
Step 3 – Allocation: $3,750 ÷ 4 years = $937.50 per year
Step 4 – Taxation:
- 2025 portion ($937.50) = ordinary income this year
- 2022–2024 portions ($2,812.50) = taxed at top rates for those tax years beginning in your holding period, plus interest charges
Result: A much higher tax liability than if you had simply been taxed on capital gains annually.
How Do Deferred Tax and Interest Charges Work Under PFIC Rules?
When an excess distribution occurs, the IRS spreads the income across the entire shareholder’s holding period, creating deferred tax on the amounts tied to prior years. On top of this, interest charges are added as if the tax should have been paid earlier, which greatly increases the final tax liability.
These rules apply whether the PFIC is a foreign mutual fund, a controlled foreign corporation, or another foreign corporation that fails the income test or asset test. Without a QEF election or mark to market election, expats remain subject to these strict pfic rules on their U.S. tax return.
How Do Elections Change the Picture?
The IRS does give you ways out of the harsh default rules.
1. Qualified Electing Fund (QEF) Election
- With a QEF election, you include your share of the PFIC’s ordinary earnings and net capital gain each year in your tax return.
- Since you’re paying as you go, the excess distribution allocated rule doesn’t apply.
- But: You need a PFIC annual information statement from the fund, and many foreign mutual funds won’t provide it.
2. Mark-to-Market Election
- If your PFIC is publicly traded or regularly traded, you can make a mark-to-market election.
- Each year, you report the change in fair market value of your PFIC shares.
- Gains are taxed as ordinary income, losses as capital losses (with limits).
- Again, since you’re taxed annually, there’s no retroactive allocation.
Side-by-Side Example: Default vs. QEF vs. Mark-to-Market
Imagine you hold PFIC shares worth $20,000 in 2022, and by 2025 they grow to $30,000.
- Default Rules (no election):
- You sell in 2025 and realize a $10,000 gain.
- The IRS treats the $10,000 as an excess distribution, allocates it over 2023–2025, and taxes prior-year chunks at the highest ordinary income rates plus interest charges.
- Effective tax rate is often far higher than normal.
- QEF Election:
- Each year, you report your share of the PFIC’s annual earnings.
- Instead of a $10,000 bomb in 2025, you’ve paid tax gradually.
- The 2025 sale is mostly tax-free since you already reported the income.
- Mark-to-Market Election:
- Each year, you report the annual change in fair market value.
- If the PFIC rose $3,000 in 2024, you’d pay tax then.
- By 2025, no giant surprise bill—because income has been taxed annually.
What Are the Reporting Requirements?
No matter which path you take, if you own PFICs you must file Form 8621 every tax year. This applies whether you hold:
- Specified foreign financial assets under FATCA rules
- Other foreign financial assets that fall into PFIC status
Missing reporting requirements can invalidate your tax return and extend the IRS statute of limitations indefinitely.
For the filing details, see our full guide to Form 8621.
Common Examples of PFIC Investments
The most common examples of PFICs for U.S. expats are foreign mutual funds, foreign ETFs, and pooled foreign investments offered by banks or insurers. Certain controlled foreign corporations that hold mostly passive assets can also fall under PFIC classification. Even if you think you are investing in ordinary mutual funds, buying them abroad almost always creates a PFIC taxation issue.
That’s why many Americans living overseas are surprised when these accounts trigger strict reporting requirements under U.S. tax law.
Bottom line: U.S. expats should think very carefully before buying foreign mutual funds or other PFICs. The excess distribution rules can turn what looks like a simple investment into one of the costliest mistakes abroad. Professional tax planning can help you choose between the default, QEF election, or mark-to-market election so you don’t get caught by surprise.
