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Strategies for dealing with the kiddie tax—Part II

The “kiddie tax,” i.e., the Code Sec. 1(g) provision that taxes unearned income of certain children as if it were the income of their parents, is a rule that parents of children under the age of 24 should consider. In Part I of this two-part Practice Alert (see Weekly Alert ¶  45  08/28/2015), we discussed how the kiddie tax works and how to avoid it. In this Part II, we discuss: a) how persons who are subject to the tax should choose between the two tax forms that are available to report the kiddie tax, and b) some planning moves that become valuable, or whose value increases, to a taxpayer who is able to avoid the kiddie tax.

RIA observation: The kiddie tax rules contain several dollar amounts that are inflation adjusted. All dollar amounts in this article are amounts that apply for 2015.

See Part I of this Practice Alert (Weekly Alert ¶  45  08/28/2015) for a detailed explanation of how the kiddie tax works.

Reporting the kiddie tax; Form 8814 or Form 8615? Generally, a dependent child must file a tax return if his gross income exceeds the standard deduction for a dependent. See Code Sec. 6012(a)(1)(A), Code Sec. 63(c), and Code Sec. 151(d)(2). And, generally, if that child is subject to the kiddie tax, he must use Form 8615, Tax for Certain Children Who Have Unearned Income, to compute his tax.

However, in some cases, parents may elect to report a child’s income on their return and not file a separate return for the child. (Code Sec. 1(g)(7)) The election is made by attaching Form 8814, Parent’s Election To Report Child’s Interest and Dividends, to the parents’ return. Filing Form 8814 is allowed only if all of the following apply: (2014 Form 8814, updated to reflect Rev Proc 2014-61, 2014-47 IRB 860)

1. The child has not attained age 18 as of the close of the tax year; or his earned income does not exceed half of his support and he is either (a) age 18 or (b) a full-time student age 19-23 at the end of the year;
2. The child’s income is comprised entirely of interest and dividends (including capital gain dividend distributions and Alaska Permanent Fund dividends);
3. The child’s gross income is more than $1,050 and less than $10,500;
4. The child is required to file a return but does not file a joint return;
5. No estimated tax or backup withholding payments for the current year have been made in the child’s name and social security number;
6. No federal income tax was withheld from the child’s income; and
7. The parents file a joint return or, if filing separate returns, the parent with the higher taxable income makes the election.

How to choose between Form 8615 and Form 8814. While in many cases, using Form 8814 won’t have a tax cost or a tax advantage to the family, in many other cases it will. Assuming a taxpayer has a child who is subject to the kiddie tax and that he has the choice between the two forms, which one should he choose?

Advantages of electing to file Form 8814 and report the income on the parents’ return.

  • Saves time, particularly where there is more than one child involved. Fewer taxpayers, just one form (Form 8814) as opposed to a separate return, fewer checks to write, no separate estimated tax filing for the child, etc.
  • Should result in a lower tax return preparation fee.
  • If the parents have more investment interest than net investment income, allows more of that interest to be deductible in the current year. (See Code Sec. 163(d)(1))
  • The child’s capital gain distributions may be used to offset the parents’ capital losses.
  • RIA observation: But, note that a parent’s capital gain distributions (or other capital gains) can’t offset a child’s capital losses, because Form 8814 can’t be used if the child has capital losses.
  • Increases parents’ AGI for computing charitable contribution limits.
  • Possible alternative minimum tax (AMT) savings. Making the election could reduce total family taxes in the rare case where the child has substantial interest income from tax exempt private activity bonds that would be subject to the AMT in the child’s hands but not in the parents’ hands because of their much higher AMT exemption.
  • Could save state income taxes. Here’s one example. The mechanics of computing the kiddie tax when Form 8814 is filed are that $105 (10% federal tax on the $1,050 income) is added directly to the federal tax shown on line 44 of Form 1040—i.e., the $1,050 is not included in the parents’ federal taxable income. Where the state starts with federal taxable income in determining state income, that $1,050 escapes state taxation.

Advantages of filing Form 8615 and reporting the income on the child’s separate return.

  • Reduction of tax breaks that are limited by AGI. Income picked up under the Form 8814 election increases the parents’ AGI and could reduce deductions or other tax breaks of the parents that are geared to AGI. Parental items that could be affected include deductions for medical expenses, casualty losses, traditional and Roth IRA contributions and student loan interest; miscellaneous itemized deductions; itemized deductions affected by the overall limitation on itemized deductions; personal exemptions; the credit for child and dependent care expenses; the child credit; the earned income credit; the adoption credit; education credits; the exclusion for employer-provided adoption assistance; and the exclusion for interest on savings bonds used for education.
  • Loss of child’s deductions. The election precludes taking the following that would be available on the child’s tax return: additional standard deduction for blindness, deduction for penalty on early withdrawal of savings, and the child’s itemized deductions (such as the child’s investment expenses or charitable contributions). (IRS Publication 929, p. 10)
  • Increased estimated taxes for the parents, where, in some cases, the child wouldn’t have had to make estimated tax payments.
  • Child’s income is more likely to become subject to the 3.8% net investment income (NII) tax due to parents’ higher AGI.
  • RIA observation: A child who files Form 8615 will not pay NII tax because of his parents’ tax situation. The “allocable parental tax,” which is the extra tax the child will pay as a result of the kiddie tax, is the excess of the tax the parents would pay under Code Sec. 1 if unearned income of the children were added to the parents’ return, over the tax imposed by Code Sec. 1 if the children’s unearned income were not added. (Code Sec. 1(g)(3)(A)) As the NII tax is imposed by Code Sec. 1411 and not by Code Sec. 1, it is not a part of this calculation.
  • If the child received qualified dividends or capital gain distributions, the parents may pay up to $105 more in tax by making the election. That’s because, the tax rate on the child’s income between $1,050 and $2,100 is 10% if the parents make the election. However, if the election is not made, the tax rate on that $1,050 may be as low as 0% because of the preferential tax rates for qualified dividends and capital gain distributions.
  • Could cause increased state income taxes. For example, unlike the federal income tax, many states allow dependent children to take a personal exemption on their returns. In states that allow the child’s income to be reported on the parents’ return, that exemption is generally lost. New York is an example of a state where the exemption is lost.

Planning moves for taxpayers who avoid the kiddie tax. Here are some moves to make if the taxpayer has a child who is in a low tax bracket and the taxpayer isn’t subject to the kiddie tax. Note that these are just a few of the possibilities.

Transfer appreciated assets to the child. A child who is not subject to the kiddie tax is subject to 0% tax on net capital gains and qualified dividends if he is unmarried and his taxable income (including those gains and dividends) isn’t more than $37,450. (A higher limit applies if he is married-filing-jointly or a head of household.) Thus, his parent can transfer appreciated property to him, and he can sell it at no federal tax cost if his income is below this limit. This also means that his parent can give appreciated property to him, have him sell it at no tax cost, and the parent can then immediately repurchase the stock and get a higher tax basis, i.e., a tax basis equal to the current value of the property.

RIA observation: Unlike the wash sale rule in Code Sec. 1091, there is no rule that precludes selling property at a gain or transferring it to a related party who sells it for a gain, recognizing the gain, and then repurchasing the property quickly thereafter.

Do other “income splitting” moves. For example, the parent can make gifts to his child of income-producing property, so that the income is taxed in the child’s bracket. For the significant number of taxpayers who are no longer concerned with gift and estate taxes because of the large exemption that applies to those taxes, the taxpayer need not be concerned with the $14,000 ($28,000 if the gift-splitting election for married couples is made) limitation on the annual gift tax exclusion. Other taxpayers should give that limitation consideration but need not necessarily be limited by it in making their gifts of income-producing property.

But, for both of the above moves, consider their effects on eligibility for college financial aid. If need-based college financial aid is relevant even though the kiddie tax is not, remember that the standard formula for needs-based financial aid reduces financial aid more based on a given amount of the student’s assets than on that same amount of the parents’ assets.

Steps to take if the taxpayer was subject to the kiddie tax in the past, but is no longer subject to it. If parents took certain steps to avoid the kiddie tax in the past, and now the child meets the earned income test and/or is old enough that the kiddie tax doesn’t apply, the parents should review the steps that they took to avoid the kiddie tax and consider reformulating their tax strategy to take into account the changed circumstances. For example, an emphasis on stocks that didn’t pay dividends, which was a good strategy while the kiddie tax applied, is likely to not be as good a strategy after the kiddie tax is no longer a factor.

References: For the kiddie tax, see FTC 2d/FIN ¶  A-1300; United States Tax Reporter ¶  14.09; TaxDesk ¶  568,300; TG ¶  1050.

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