The “Kiddie Tax” was enacted in 1986 and was intended to close a tax loophole that allowed a small number of wealthy parents to reduce their tax bill by shifting income-producing assets to their young children in lower a tax bracket. Originally the law provided that, for any child who was under the age of 14 at the end of the tax year, any unearned income (such as dividends and interest) of the child over $2,000 would be taxed at the higher of the child’s marginal tax rate or the parent’s. In May of 2006, Congress passed the Tax Increase Prevention and Reconciliation Act, raising the application of the kiddie tax from under age 14 to under age 18. Just a year later, the Small Business Work Opportunity and Tax Act of 2007 increased the age to under 19, or 24 for full-time students. The rising age application may have served its purpose of raising tax revenues, but it also lost the original intent of the legislation and more often hurts middle class families paying for college.
The age of 14 in the original legislation was chosen first because it was the age at which children may work in certain employment under the Fair Labor Standards Act and second, to minimize complexity. It was thought that children above the age of 14 were more likely to have earned income, and thus had substantially more complicated financial situations. The later increases in the age from 14 to 23 vastly increased the number of taxpayers required to deal with the complexity. According to a 2010 report by the President’s Economic Recovery Advisory Board, about half of kiddie tax filers at that time were college students, and about 40% were between the ages of 14 and 18, meaning that only 10% of the filers were the intended targets of the original legislation.
The law provides a method for parents to “simplify” reporting of their children’s unearned income by including the child’s income on the parent’s own return instead of filing a separate return for the child. This “simplified” method comes with its own set of complexities: the child’s investment income can consist only of interest, dividends, and certain capital gain distributions. Sales of securities will make the child’s income ineligible for reporting on the parents return. Also, no estimated tax payments can have been made in the child’s name. Even if eligible for the simplified method, reporting the child’s income on the parent’s return can have negative tax consequences. If the child received qualified dividends or capital gain distributions, the election may result in a higher tax than if a separate return for the child was filed. Also, choosing to include the child’s income on the parent’s return may increase the parent’s adjusted gross income (AGI) to the extent that it may trigger the phase-out of deductions, personal exemptions, and credits on the parent’s return that are based on AGI. It can also reduce IRA contributions and increase the taxable portion of Social Security benefits.
Filing a separate return for the child presents its own set of challenges. Parents with more than one child subject to the Kiddie Tax must determine the tax attributable to each child and a child with an otherwise simple return cannot file until the parent’s return is filed.
Often, a child’s income is not a result of income shifting from a parent, but comes from an inheritance, insurance settlement, or gifts from a grandparent or other family member. Early drafts of the original legislation attempted to address these circumstances by making a distinction between parental and non-parental-source incomes, but such a segregation of assets was (correctly) determined to be an “administrative and compliance nightmare” and the distinction was dropped.
There are still a few methods available to reduce or eliminate a hit from the Kiddie Tax. First, if possible, keep the dependent child’s unearned income under $1,900 per year by choosing investments for your children that don’t generate current taxable income, such as growth stocks and mutual funds geared toward capital appreciation. Second, defer gifts of cash and investments to the dependent child until they are age 24, or 19 if not a full-time student. Finally, for college savings, take advantage of 529 accounts instead of UTMA custodial accounts, as the investments in 529 accounts can grow and be withdrawn tax free as long as the funds are used for qualified education expenses.
By Janet Berry-Johnson, CPA