Why the child, not the parent, is the taxpayer

A grandmother in Singapore, a father in Zurich or an aunt in Dubai sets up a trust for a child’s schooling. The child holds a U.S. passport, often through a parent or a U.S. birth, and may never have lived in the United States. The family sees a gift. The IRS sees a U.S. person receiving money from a foreign trust, and it expects a form every year. Many parents find this out years later.

Why the child, not the parent, is the taxpayer

The IRS states that a U.S. citizen living abroad is “subject to tax on worldwide income from all sources” under the same rules as a citizen at home [1].

A trust set up by a non-U.S. relative is a foreign trust unless a U.S. court supervises it and U.S. persons control its major decisions [2]. A child with a U.S. passport who benefits from a family trust abroad therefore has her own U.S. filing duties.

Being a minor is not an exemption. The IRS tells parents that “if a child can’t file their own FBAR for any reason, such as age, the child’s parent or guardian must file it for them” [3], and that if a child cannot sign a tax return, “either parent can sign the child’s name” and add “By (your signature), parent for minor child” [4].

The filings are the child’s; the parent’s job is to make them.

What counts as a distribution

Parents often assume nothing needs to be reported because the child never touched the money.

The IRS defines a distribution as “any gratuitous transfer of money or other property from a foreign trust, whether or not a portion of such trust is treated as a grantor trust,” and says it “also includes constructive transfers” [2].

Tuition wired to the school, a laptop bought by the trustee, a flight paid from the trust account: each is a distribution to the child. So is a loan from the trust, or rent-free use of a trust-owned apartment [5].

Sources: [6] [2] [3] [7]

The three forms

Form 3520. Required for any year the child receives a distribution, directly or indirectly, from a foreign trust [2].

It is an information return, not a tax bill, but the penalty for skipping it is the greater of $10,000 or 35 percent of the amount received [6]. Until a complete form is filed, the IRS’s time to assess tax stays open [2].

FBAR. A U.S. person with “a present beneficial interest in more than 50 percent of the assets” of a trust must report the trust’s foreign accounts once they total more than $10,000, unless a U.S. trustee or agent files for the trust [8]. A sole beneficiary is the clearest case.

Form 8938. Filed with the child’s tax return if her foreign financial assets exceed $200,000 at year end or $300,000 at any time while she lives abroad. A trust interest counts once she receives a distribution, because she is then “considered to know of the interest” [7].

Whether tax is owed depends on the trust

Reporting and tax are separate questions. If the relative who funded the trust can revoke it alone, “without the approval or consent of any other person,” the trust is treated as hers for U.S. purposes [9], and payments to the child are gifts.

The child proves this by attaching a Foreign Grantor Trust Beneficiary Statement from the trustee and treating the payment “as if it came directly from the owner” [2]. Without the statement, part of each payment is treated as taxable income [2]. Few foreign trustees produce it unless a parent asks.

The picture changes when the relative dies, or when the deed requires a trustee’s consent to revoke, which the regulations treat as failing the test [10].

The trust then becomes a separate taxpayer. Income kept inside it becomes “undistributed net income” [11], and when paid out years later the child owes tax plus an interest charge for each year it sat in the trust [12]. Local mutual funds in such a trust add a further layer, since a beneficiary is treated as owning the units in proportion to her interest [13].

Sources: [2] [9] [10] [14]

Fixing missed years

The IRS says “no penalties will be imposed if the taxpayer can demonstrate that the failure to comply was due to reasonable cause and not willful neglect” [2].

Under the delinquent information return procedures, a taxpayer not already under examination files the late forms and “may attach a reasonable cause statement” to each, though the IRS warns that penalties “may be assessed without considering the attached reasonable cause statement” [14].

For a child living abroad whose failure was not willful, the Streamlined Foreign Offshore Procedures are usually the better path.

A taxpayer who qualifies and follows the instructions “will not be subject to failure-to-file and failure-to-pay penalties, accuracy-related penalties, information return penalties, or FBAR penalties” [15].

The procedures require tax returns with all information returns for “the most recent 3 years,” FBARs for “the most recent 6 years,” and a signed certification that the failure “resulted from non-willful conduct” [15].

The sequence that works

1. Gather the trust deed and payment history. Every payment for the child, by year, and the trust’s account balances.
2. Classify the trust. Who can revoke it, and with whose consent, decides whether the child owes tax or only a form.
3. Choose the repair route. Streamlined where the child lives abroad and the failure was not willful; delinquent-return filing with a reasonable cause statement otherwise.
4. Set up the annual cycle. Trustee statement, Form 3520, FBAR and, where thresholds are met, Form 8938 each April.

Sources: [2] [15] [14] [8]

This article is for general informational purposes only and does not constitute legal or tax advice. Outcomes depend on the facts of each matter and no result is guaranteed. Reading it does not create an attorney-client relationship with Dilendorf Law Firm. Prior results do not guarantee a similar outcome. Attorney Advertising.