PFIC Tax Calculation: The Excess Distribution Method With a Worked Example

The default PFIC tax calculation is the excess distribution method in section 1291. A gain on selling the fund, or an unusually large distribution, is spread evenly over every day you held it. The slice for the current year is ordinary income. Each earlier year's slice is taxed at that year's top rate, and interest is charged as if the tax had been due back then. The result is usually a higher bill than tax on the same gain from a US fund. This guide works through the arithmetic one step at a time.

When does the excess distribution method apply?

It applies to any PFIC for which you have made neither a qualified electing fund election nor a mark-to-market election. The IRS calls that a section 1291 fund. Most UK funds held by Americans are in this position by default, because no one made an election in the first year. Our guide to the PFIC definition explains which holdings are caught.

While you simply hold a section 1291 fund, nothing is taxed. The calculation is triggered by two events:

• a disposition of the stock at a gain. The Instructions for Form 8621 treat stock as disposed of if it is sold, transferred or pledged; or
• an excess distribution, meaning a year's distributions that are large compared with the previous three years.

Both are computed in Part V of Form 8621, with a separate Part V for each one.

How is the PFIC tax calculation done, step by step?

The calculation has six steps. The first only applies to distributions; a gain on sale goes straight to step two.

1. Find the excess distribution. Take the average distributions of the three preceding tax years, multiply by 125%, and subtract the result from this year's distributions. A gain on sale is all excess.
2. Allocate it to each day of the holding period. Divide by the number of days you held the stock, ending on the date of the sale or distribution, and total the daily amounts by tax year.
3. Tax the current-year slice as ordinary income. It goes on your return at your own rate, together with any slice for years before the company was a PFIC.
4. Tax each earlier year's slice at that year's highest rate. Your actual bracket in those years is irrelevant.
5. Subtract any foreign tax credit allocated to those years, without going below zero.
6. Add interest on each earlier year's tax, from that year's return due date to this year's.

Steps four to six together produce what section 1291(c) calls the deferred tax amount. It is added to your tax for the year on top of everything else.

The 125% test for distributions

Ordinary, steady dividends from a section 1291 fund are not excess distributions. The test is whether this year's total is more than 125% of the three-year average. On the December 2025 Form 8621 that is lines 15a to 15e.

Form 8621 line	What it is	Example
15a	Distributions this year	$1,500
15b	Distributions in the 3 preceding years ($400 + $500 + $600)	$1,500
15c	Line 15b divided by 3	$500
15d	Line 15c multiplied by 125%	$625
15e(1)	Line 15a minus line 15d: the excess distribution	$875

In this example $625 is taxed as an ordinary distribution and $875 goes through the allocation, top-rate tax and interest steps. Three details matter in practice:

• The first year is exempt. Section 1291(b)(2)(B) sets the total excess distribution at zero for the tax year in which your holding period begins.
• A fund that paid nothing for three years has an average of zero. The first payment after that is entirely an excess distribution.
• Currency. The instructions say the excess distribution is generally calculated in US dollars, but in the foreign currency if every distribution taken into account was paid in that one currency. The December 2025 form asks for the three-letter currency code and, on line 15e(2), the dollar amount.

A worked example: selling a UK fund after five years

Illustrative example: Hannah, a US citizen living in Edinburgh, buys accumulation units in a UK index fund on January 1, 2021 for the equivalent of $20,000. She makes no election and the fund pays no distributions. She sells on December 31, 2025 for $30,000. Her gain is $10,000, entered on line 15f. This is a simplified illustration that ignores exchange rate movements and UK tax, and is not advice for any specific person.

Step 1: allocate the gain to days

Hannah held the units for 1,826 days. $10,000 divided by 1,826 is about $5.48 a day. Totalled by tax year:

Tax year	Days held	Gain allocated	Treatment
2021	365	$1,998.90	Prior PFIC year
2022	365	$1,998.90	Prior PFIC year
2023	365	$1,998.90	Prior PFIC year
2024	366	$2,004.38	Prior PFIC year
2025	365	$1,998.90	Current year: ordinary income
Total	1,826	$10,000.00

This schedule is the statement that line 16a tells you to attach.

Step 2: the current-year slice

The $1,998.90 allocated to 2025 goes on line 16b and onto Hannah's 2025 return as other income, taxed at her own marginal rate.

Step 3: tax the earlier years at the top rate

The instructions list the highest individual rate as 37% for each year from 2018 to 2025. The four earlier slices total $8,001.08.

Tax year	Gain allocated	Highest rate	Increase in tax
2021	$1,998.90	37%	$739.59
2022	$1,998.90	37%	$739.59
2023	$1,998.90	37%	$739.59
2024	$2,004.38	37%	$741.62
Line 16c	$8,001.08		$2,960.39

With no foreign tax credit on line 16d, line 16e is also $2,960.39. It is added to her 2025 tax as additional tax.

Step 4: add the interest

Interest runs on each year's increase in tax from the due date of that year's return to the due date of the 2025 return. The rate is the IRS underpayment rate, published on its quarterly interest rates page, which says the rates are compounded daily. Over this period the rate moved between 4% and 8%.

Tax year	Increase in tax	Interest runs	Approximate interest
2021	$739.59	April 2022 to April 2026	$237
2022	$739.59	April 2023 to April 2026	$184
2023	$739.59	April 2024 to April 2026	$117
2024	$741.62	April 2025 to April 2026	$53
Line 16f			About $591

These interest figures use the published quarterly rates and take each due date as April 15 for simplicity, so treat them as close estimates.

The result

On the $8,001.08 allocated to earlier years, Hannah pays $2,960.39 of tax and about $591 of interest: roughly $3,551, or about 44% of that part of the gain. She then pays ordinary income tax on the remaining $1,998.90. Nothing is taxed at long-term capital gains rates, even though she held the fund for five years.

Why does the bill grow the longer you hold?

Because both moving parts get worse with time. A longer holding period pushes a larger share of the gain into earlier years, where the top rate applies, and gives the interest more years to compound. In the example, the 2021 slice carries more than four times the interest of the 2024 slice on the same amount of tax.

Two further rules add to the cost:

• Losses are ignored. A loss on one section 1291 fund is not taken into account under section 1291 and does not reduce the gain on another within this calculation. The instructions add that the loss may be recognized under another provision.
• Each block is separate. If you bought units on several dates, perhaps through a monthly savings plan, each purchase has its own holding period and its own allocation. A regular investor can have dozens of small calculations for one fund.

How does it compare with making an election?

	Excess distribution (no election)	Mark-to-market	Qualified electing fund
When tax arises	On sale or excess distribution	Every year, on the rise in value	Every year, on your share of the fund's earnings
Rate	Top rate for earlier years; your rate for the current year	Your ordinary rate	Your ordinary rate on earnings; long-term capital gain rate on the fund's net capital gain
Interest charge	Yes	No	No
Losses	Not taken into account	Deductible up to earlier inclusions	Not passed through
What you need	Purchase dates, costs and distribution history	Year-end values; stock must be marketable	A PFIC Annual Information Statement from the fund

Had Hannah elected mark-to-market in 2021, she would have paid tax at her own rate on each year's increase as it arose, with no top-rate tax and no interest. That is why the election decision belongs in the first year. The elections themselves are made on Form 8621; our Form 8621 instructions guide shows where.

What do you need to run the numbers?

1. The purchase date and dollar cost of every block of units, including reinvested distributions and monthly contributions.
2. Every distribution received, by date, for the current year and the three before it.
3. The sale date and proceeds in dollars.
4. Any UK tax withheld or paid on the distribution, for the line 16d credit.
5. The highest tax rate for each year of the holding period, from the Form 8621 instructions.
6. The quarterly underpayment rates from the IRS for the interest calculation.

Platform statements usually supply the first three, though older records can be hard to recover after a provider merger. Reconstructing them is often the slowest part of the job.

What people get wrong in a PFIC tax calculation

• Using their own tax bracket for the earlier years. The law uses the highest rate for each year, even for someone who had no US tax to pay at the time.
• Treating the gain as capital gain. No part of a section 1291 gain is long-term capital gain.
• Forgetting the interest. The tax on line 16e and the interest on line 16f are separate amounts, and the interest is not optional.
• Netting gains against losses. Each fund stands alone in this calculation.
• Ignoring fund switches inside an ISA. Moving from one fund to another is a sale of the first one. The ISA wrapper changes nothing for US tax, as our article on ISAs and PFICs explains.
• Assuming small dividends are always safe. A payment after years of none is entirely an excess distribution.

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. We run the PFIC tax calculation for each fund and each block of units, compare the cost of staying in the default rules with making an election, and prepare the Forms 8621 alongside your US and UK returns. For cross-border investors who want to stop the problem growing, our guide to investing as an American in the UK sets out what to hold instead. To have your own figures worked out before you sell, contact us.