Americans living abroad will frequently do a sensible thing, and invest in foreign mutual funds. That’s a good investment strategy.
But when that American is a kid? Foreign mutual funds make trouble. They may require the child to file a U.S. tax return, even if the child has trivial amounts of income:
As so often happens, an American abroad falls in love and marries a local. Children ensue. The kids are U.S. citizens for reasons known only to God and the Immigration and Nationality Act.
Mom and Dad do the usual: they open a little investment account for their kids. As is entirely normal, the account holds publicly traded mutual funds. It’s a sound investment strategy.
A typical example of these accounts might be a Junior ISA in the United Kingdom (or its predecessor, the Child Trust Fund). These are accounts where parents can make annual contributions. Income is tax-free in the U.K.
Every U.S. citizen is required to file a tax return if income levels exceed a minimum threshold. Even babies.
For a minor who can be claimed as a dependent on someone else’s tax return, there is a special rule: if investment income is under $1,050, the minor need not file a tax return, and the income is tax-free. As usual, there are exceptions. Don’t take this write-up to the bank.
For a parent who has opened a Junior ISA or Child Trust Fund for a kid, it is entirely probable that interest, dividends, and capital gain distributions from mutual funds would be under the $1,050 amount for the year. This is the happy place:
Even if the child’s annual investment income is under $1,050, the PFIC problem can require a tax return — even if the child’s investment income is $1.
The U.S. tax system thinks that foreign mutual funds are Passive Foreign Investment Companies. PFICs. (Pronounced “PEE-fick”, if you want to sound intelligent at a cocktail party.)
If you own a PFIC, you are required to file Form 8621 every year.
Except as otherwise provided in this section, a United States person that is a shareholder of a PFIC must complete and file Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund” (or successor form), under section 1298(f) and these regulations for the PFIC if, during the shareholder’s taxable year, the shareholder directly owns stock of the PFIC . . . .1
If you are required to file a Form 8621, you must attach it to an income tax return filed for that year.2
In other words, if you own PFICs (in the form of foreign publicly traded mutual funds) and you earn zero income, you must still file a U.S. income tax return. Even if you’re a kid.
Fortunately, there are exceptions to the “you must file Form 8621” commandment.
One of the exceptions is the de minimis exception. If the total amount of PFICs owned is under $25,000, you are not required to file Form 8621:3
A shareholder is not required under section 1298(f) and these regulations to file Form 8621 (or successor form) with respect to a section 1291 fund (as defined in Sec. 1.1291-1T(b)(2)(v)) for a shareholder’s taxable year if . . . [o]n the last day of the shareholder’s taxable year . . .[t]he value of all PFIC stock owned directly or indirectly under section 1298(a) and Sec. 1.1291-1T(b)(8) by the shareholder is $25,000 or less . . . .
That’s really good. A normal kiddie with a normal parent-funded account (like a Junior ISA or Child Trust Fund) is likely to have less than $25,000 of mutual funds. This means no mandatory Form 8621 filing requirement, and, if the child’s investment income (interest, dividends, capital gain distributions) is under $1,050, there is no mandatory income tax return filing requirement either.
The de minimis exception, naturally, has exceptions.
One exception kills our happiness. You must file Form 8621 (attached to its designated carrier pigeon, the Form 1040) if you receive even $1 of “excess distribution” from a PFIC.
The $25,000 exception (“you don’t have to file Form 8621”) applies to a shareholder who owns $25,000 or less of PFIC stock and:
. . . is not treated as receiving an excess distribution (within the meaning of section 1291(b)) with respect to the section 1291 fund during the taxable year or as recognizing gain treated as an excess distribution under section 1291(a)(2) as the result of a disposition of the section 1291 fund during the taxable year. . . .4
So, doting parent of a minor American citizen abroad. Your child’s Junior ISA has $5,000 of mutual fund shares in it. You have satisfied the first of the two requirements: total PFIC value under $25,000.
What about the second requirement? Did the foreign mutual funds in your kid’s Junior ISA generate an “excess distribution”?5
Here is where an “excess distribution” might occur: every year, a small fraction of shares is sold for cash, and the cash is used to pay a management fee. In the right circumstances, the cash generated from the sale of the foreign mutual funds can be an “excess distribution” from a PFIC.
I will leave the concept of “excess distribution” for another time and place.6
No good deed goes unpunished. Parents funding an investment account for their U.S. citizen children may inadvertently cost themselves a lot of money in U.S. tax analysis and tax return preparation if the account owns foreign mutual funds.
These mutual funds are PFICs. It is highly probable that Form 8621 will be required. All that is necessary is a dollar of “excess distribution” from the PFIC. This will take work to figure out.