The PFIC Talk: Why Congress Made Your Israeli Savings Account a Tax Nightmare
by I. David Waxman
Every week, I have “the PFIC talk” with several clients. The conversation always hits on the “why” question. Why does the US government want to punish me for saving money and opening a kupat gemel?
At one level, the question is irrelevant. We’re tax accountants, darn it, not philosophers. But nonetheless, we as humans naturally look for order and logic amidst the chaos. The demands of US tax compliance for dual US-Israeli citizens are indeed onerous (in my opinion) and difficult to cope with.
In the best case scenario, this dual citizen must avoid many common investment and savings vehicles that their non-US citizen friends and neighbors are able to freely invest in. In the worst case scenario, they’re saddled with additional taxes and compliance fees. Many of these products are marketed for their preferential tax treatment in Israel, but the impact of US compliance will often turn this tax-deferred dream into a tax and compliance nightmare.
If you’re looking for the TLDR, there is no satisfying answer. There’s just a series of events that led to some congressmen passing legislation that is making your life in Israel (and other countries) difficult.
Note – if you want to skip the history and jump straight to practical solutions, then jump to this article: https://colewaxman.com/pfics-a-practical-guide-to-the-perplexed/
The Origin Story: From PDICs to PFICs
Before we talk about PFICs (passive foreign investment companies), let’s talk about PDICs (passive domestic investment companies). I’ll confess that “PDIC” is not a term that anyone uses—I just made it up. But I want to use this term to help understand the background that led some congressional subcommittee lawyers to invent the term “PFIC.” Prior to 1986, “PFIC” also was not a term that anyone used.
How “PDICs” Work
Typically, the government shares in the profits of investments on a “pay as you go” basis. That is, as you earn investment income, you include this income on your annual income tax return and thereby pay your “fair share” of the profits to your benefactor known as the US government.
This is the purpose of a 1099 or K-1 form that you receive from your bank, brokerage firm, or S-corporation partnership. These forms report your investment income in the form of interest, dividends, capital gains, rents, distributions, etc. The IRS also gathers this information and will review your tax filing to confirm compliance. If you neglect to include part or all of this income, then no worries—the IRS has your back and they’ll remind you by sending a CP2000 underreporting notice and also add some penalties for good measure.
But all of the above only applies to “PDICs”—financial entities that fall under the legislative and regulatory authority of the United States.
1968-1981: The Golden Era of Offshore Investing
On January 12, 1981, IRS attorney Richard A. Gordon published “Tax Havens and Their Use by United States Taxpayers – An Overview.” The report was a response to the rapid growth of offshore financial activity, with U.S. direct investment in foreign corporations nearly tripling from 1968 to 1978 (from approximately $70 billion to $200 billion) and earnings increasing fourfold.
Wealthy investors were able to save on their annual tax assessments by moving their funds offshore to foreign entities that were all too eager to accommodate the wishes of their American patrons. These savings included a mix of legal and not-at-all-legal tactics.
Legal tactics might include tax deferral. Foreign entities could (and would) defer the declaration of annual investment income by using their local bookkeeping regulations. This would effectively create something similar to a traditional IRA or 401(k) that deferred taxation indefinitely until the time of withdrawal. The added value for our wealthy tax schemers was that these vehicles would not be limited by annoying regulations such as:
- Limits on deposit amounts
- Gross annual income restrictions
- Required minimum distributions
- Age-based withdrawal rules
For those looking for even higher tax savings, wealthy investors would exploit foreign entities that would simply help their clients hide their assets and income. This is otherwise known as tax evasion and is quite illegal. Al Capone couldn’t beat that rap—maybe he should have parked his extra cash in the Cayman Islands too?
The Writing on the Wall
By the early 1980s, the party was clearly coming to an end. High-profile cases were making headlines:
- Leona Helmsley became the poster child for wealthy tax avoidance with her infamous quote: “We don’t pay taxes; only the little people pay taxes.” Her conviction in 1989 for evading over $1 million in taxes through fraudulent schemes captured public attention.
- Corporate inversions began with McDermott International’s 1983 move to Panama, saving the company about $200 million in taxes by restructuring to avoid U.S. corporate taxes on foreign profits.
- Tax haven activity exploded, with about half of all international banking assets flowing through offshore centers.
The IRS’s 1981 Gordon Report laid bare the scope of the problem, documenting how wealthy Americans were systematically using foreign entities to defer or evade taxes on massive scales.
1986: The Tax Reform Act Strikes Back
In the mid-1980s, the public was concerned with rising budget deficits. In 1986, the federal budget deficit clocked in at $221 billion. In today’s terms, while we are approaching a $2 trillion deficit, that seems quite tame. But at the time, it was quite alarming.
Enter the Tax Reform Act of 1986 (H.R. 3838), sponsored by Democrats Richard Gephardt in the House and Bill Bradley in the Senate, and signed by Republican President Ronald Reagan. This bipartisan legislation included the creation of PFIC rules as part of a broader effort to close tax loopholes and make the wealthy pay their “fair share.”
The PFIC provisions were designed to put U.S. investors in foreign passive investment vehicles on equal footing with those who invested in similar U.S. vehicles. If you wanted the benefits of U.S. citizenship and legal protections, Congress reasoned, you should pay U.S. taxes on your investment income—even if that income was generated overseas.
The Unintended Consequences
Here’s where the story gets frustrating for modern expatriates and dual citizens. The PFIC rules were crafted primarily to target wealthy Americans hiding money in Caribbean tax havens and sophisticated offshore investment schemes. But the broad language of the law swept up ordinary retirement savings, insurance policies, and investment funds that are perfectly normal and legitimate in countries around the world.
Your innocent kupat gemel in Israel? It likely meets the technical definition of a PFIC because:
- It’s a foreign corporation (from the U.S. perspective)
- More than 75% of its income comes from “passive” sources like dividends and capital gains
- Or more than 50% of its assets produce passive income
The result? What should be a simple retirement account becomes subject to:
- Punitive tax rates on distributions
- Interest charges calculated back to your original investment date
- Complex annual reporting requirements on Form 8621
- Professional compliance costs that can easily exceed your annual returns
The Bottom Line
The PFIC rules represent a classic case of legislation designed to catch sophisticated tax avoiders that ended up ensnaring ordinary people living normal lives abroad. While the original intent—preventing wealthy Americans from hiding money offshore—was arguably reasonable, the execution created a compliance nightmare for dual citizens and expatriates who simply want to participate in their local country’s normal savings and investment vehicles.
Understanding this history doesn’t make the rules any less burdensome, but it does help explain why Congress thought it was a good idea to create these rules in the first place. The wealthy tax schemers of the 1970s and early 1980s essentially ruined it for everyone else.
So the next time you’re wondering why your perfectly reasonable Israeli investment account is causing tax headaches, remember: you can thank the tax avoiders of the 1980s and the congressional response that followed. Sometimes, being in the wrong place (tax-wise) at the wrong time means dealing with rules that weren’t really designed for people like you.
Practical Solutions
These complications apply to kupat gemel and many other popular investment vehicles that your typical Israeli bank or investment advisor might recommend because he is not aware of US tax traps. If you’ve gotten this far, then you’re probably wondering how you can avoid these complications or mitigate them if you’re already invested in PFIC’s. Stay tuned for our next installment in the PFIC series for some practical suggestions.
This article is for informational purposes only and should not be considered specific tax advice. PFIC rules are complex and fact-specific. Always consult qualified tax professionals for guidance on your particular situation.