Excess Distribution PFIC Rules: Why Holding Longer Costs More

Under the excess distribution PFIC rules, the same gain costs more the longer you held the fund. Section 1291 spreads the gain over every day of the holding period, taxes each earlier year's share at that year's top rate, and adds daily-compounding interest from each year's return due date. More years means more of the gain taxed at past top rates, and more interest on the oldest slices. This guide shows how fast that adds up and what can stop it.

Our earlier guide to the PFIC tax calculation works through the six steps line by line. This article looks at one question: what time does to the bill.

What is an excess distribution PFIC charge?

An excess distribution PFIC charge is the extra tax and interest that section 1291 adds when you receive an unusually large distribution from a passive foreign investment company, or sell its stock at a gain, without having made an election. The IRS calls a PFIC held this way a section 1291 fund. Most UK unit trusts, OEICs and investment trusts held by Americans end up in this position by default. Our guide to the PFIC definition explains which holdings are caught.

The Instructions for Form 8621 define an excess distribution as the part of the current year's distributions that is more than 125% of the average distributions received on the stock in the three preceding tax years, or in the holding period if that is shorter. Section 1291(b)(2)(B) sets the excess distribution at zero for the year the holding period begins. Under section 1291(a)(2), a gain on disposing of the stock is treated in full as an excess distribution, with no 125% cushion.

Nothing is taxed while you simply hold a section 1291 fund. The cost builds up silently and arrives in one year: the year of the sale or the large distribution.

How does the holding period drive the bill?

The holding period drives the excess distribution PFIC bill through three separate effects, and all three get worse with every year you hold.

1. The gain is spread over more years

Section 1291(a)(1) allocates the excess distribution "ratably to each day" of the holding period. The Form 8621 instructions say to divide the gain by the number of days held, with the holding period ending on the date of the sale or distribution. Only the slice allocated to the current year, plus any slice for years before the company was a PFIC, is taxed as ordinary income at your own rate. Everything else is an earlier-year slice. Hold for 3 years and two thirds of the gain falls in earlier years. Hold for 20 years and 95% does.

2. Each earlier year is taxed at that year's top rate

The increase in tax for each earlier year is the slice multiplied by the highest rate in effect for that year, whatever your own income was. The Form 8621 instructions give this table for individuals:

Tax years	Highest individual rate used
2018 to 2025	37%
2013 to 2017	39.6%
2003 to 2012	35%
2002	38.6%
2001	39.1%
1993 to 2000	39.6%

For tax year 2026 the top individual rate is still 37%, according to the IRS's 2026 inflation adjustments in Revenue Procedure 2025-32. A long holding period can therefore pull part of the gain into the 39.6% years. A US citizen in the UK who paid little or no US tax in those years because of the foreign tax credit is still charged at the top rate on the slices allocated to them.

3. Interest runs on every earlier year

The Form 8621 instructions say interest is charged on each net increase in tax from the due date of the return for that year, without extensions, to the due date of the return for the year of the excess distribution. The amount is set by the rates and methods of section 6621. The IRS quarterly interest rates page shows an underpayment rate of 7% for the quarter beginning October 1, 2026, and states that the rates are compounded daily. An earlier year's slice that is 15 years old carries 15 years of compounding.

None of these effects is offset by the fund's performance. A fund that rose 3% a year and one that rose 10% a year are both allocated evenly across the days held. What changes the outcome is time.

How much more does holding longer cost? 3, 10 and 20 years compared

Illustrative example: three investors each sell UK fund units on December 31, 2025 for a gain of $30,000. None made an election and none received distributions. One bought on January 1, 2023, one on January 1, 2016 and one on January 1, 2006. For simplicity each tax year is given an equal slice of the gain, interest is calculated at a flat 7% compounded daily from April 15 after each earlier year to April 15, 2026, and foreign tax credits and exchange rate movements are ignored. Actual underpayment rates change every quarter, so a real calculation uses each quarter's published rate and will give different interest figures. This is not advice for any specific person.

	Held 3 years (2023 to 2025)	Held 10 years (2016 to 2025)	Held 20 years (2006 to 2025)
Gain per tax year	$10,000	$3,000	$1,500
Current-year slice, taxed at your own rate	$10,000	$3,000	$1,500
Gain allocated to earlier years	$20,000	$27,000	$28,500
Top-rate tax on earlier years	$7,400	$10,146	$10,530
Interest at a flat 7%	about $824	about $4,549	about $12,056
Tax plus interest on earlier years	about $8,224	about $14,695	about $22,586
As a share of the whole $30,000 gain	about 27%	about 49%	about 75%

Each investor also pays ordinary income tax on the current-year slice at their own rate. For the 20-year holder, that is the only part of the gain taxed at their own rate.

Why the interest overtakes the tax

For the 10-year holder, the 2016 slice carries $1,188 of tax at 39.6% and, at a flat 7%, about $1,043 of interest. For the 20-year holder, the 2006 slice carries $525 of tax at 35% and about $1,462 of interest, nearly three times the tax. Across all of the 20-year holder's earlier years, interest of about $12,056 is larger than the top-rate tax of $10,530. The tax on each slice is roughly fixed, but the interest compounds for longer on every older slice.

What a US fund would have cost instead

A comparable US mutual fund held for more than a year would usually produce long-term capital gain on sale, taxed at the lower capital gains rates and with no interest. That comparison is why the length of the holding period, not the size of the gain, is often the main question when we review a client's UK funds.

Do distributions trigger the excess distribution PFIC rules too?

Distributions trigger the excess distribution PFIC rules only when they jump. A fund that pays a steady income each year usually stays under the 125% line, and those payments are taxed as ordinary distributions in the year they arrive. The problem cases are:

• A fund that starts paying after years of paying nothing. The three-year average is zero, so the whole payment is an excess distribution.
• A special or capital distribution, for example after a fund merger or a large realized gain inside the fund.
• Switching from accumulation to income units partway through, so the first full year of income is large compared with the years before.

An excess distribution is allocated over the holding period in the same way as a gain, so a large payment from a fund held for many years carries the same growing tax and interest. On the December 2025 Form 8621, the 125% test is done on lines 15a to 15e.

How can you stop the charge growing?

The excess distribution PFIC charge keeps growing until the fund is sold or moved out of section 1291. These are the main options, and each has its own cost.

Option	What happens to the built-in gain	What happens afterwards
Sell the fund	Taxed now under section 1291, with interest	No further PFIC charge on that fund; reinvest in non-PFIC holdings
Late mark-to-market election	The Form 8621 instructions treat the stock as sold at fair market value, and the gain is an excess distribution	Each year's rise in value is ordinary income, with no interest charge; the stock must be marketable
Late QEF election with a deemed sale election under section 1291(d)(2)	Gain is recognized as if the stock were sold on the first day of the first QEF year and taxed as an excess distribution; a loss is not recognized	The holding period restarts on that day and the fund becomes a pedigreed QEF; the fund must provide a PFIC Annual Information Statement
Do nothing	Nothing is taxed yet	The earlier-year share and the interest both keep growing

None of these options removes the tax and interest already built up. What they do is fix the amount, so the next year does not add more. Our guide to the mark-to-market PFIC election explains when that route beats the default rules, and our Form 8621 instructions guide shows where each election is made. For UK funds, our article on HMRC reporting funds for US citizens explains how UK reporting fund status fits with the US rules.

Steps to take if you have held UK funds for years

1. List every non-US fund you hold, including those inside an ISA, a SIPP or a stocks and shares account, and the date of the first purchase of each.
2. Check which, if any, had an election. Look at past Forms 8621. If none was filed, assume each fund is a section 1291 fund.
3. Recover purchase dates and costs for every block of units, including monthly contributions and reinvested income. Each block has its own holding period.
4. Estimate the deferred tax and interest today for each fund and compare it with the estimate one year from now.
5. Compare the exit routes in the table above with your UK tax position, since a sale also has UK capital gains tax consequences.
6. Fix the reporting for the past, if Forms 8621 were missed, before or alongside the sale. The IRS About Form 8621 page links the current form and instructions.

What people get wrong about long-held PFICs

• Thinking a long holding period earns capital gains treatment. Under section 1291 no part of the gain is long-term capital gain, however long you held.
• Assuming UK tax covers it. UK capital gains tax paid on the sale does not cancel the interest charge. The Form 8621 instructions say foreign tax allocated to an earlier year only reduces the increase in tax for that year, and unused amounts cannot be carried over.
• Waiting for a better moment to sell. Each year of waiting adds a year of interest on every older slice, and moves more of any new growth into earlier years.
• Counting the holding period from the last purchase. Units bought on different dates are separate blocks, and the oldest block carries the largest interest.
• Forgetting the step-up at death. Section 1291(e) applies rules that can reduce the basis of PFIC stock inherited from a decedent, so heirs may not get the full step-up they would get on other investments.

How we help

US/UK Cross Border Tax is a firm of US CPAs and UK tax advisers working as one team, with offices in London, Manchester, New York and San Francisco. Our excess distribution PFIC work starts with the purchase history of every fund and block of units, estimates the tax and interest today and next year, and compares selling, a mark-to-market election and a deemed sale election, taking UK tax on the same sale into account. For cross-border investors with years of unreported funds, we prepare the Forms 8621 and the returns together. Our guide to investing as an American in the UK covers what to hold instead. To have your own figures worked out before you decide, contact us.