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 every parent of children under the age of 24 needs to consider. This first installment of a 2-part Practice Alert addresses how the kiddie tax works and how to avoid it.
Part II will address: 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, when a taxpayer 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.
How the kiddie tax works. The tax on the income of a child who is subject to the “kiddie tax” rules is the greater of: (Code Sec. 1(g)(1))
A. the tax that would be imposed if the kiddie tax rules didn’t apply; (Code Sec. 1(g)(1)(A)) or
B. the sum of:
i. the tax that would be imposed if the kiddie tax rules didn’t apply and if the child’s taxable income for the tax year were reduced by the child’s net unearned income (investment income minus twice the minimum basic standard deduction allowed to dependents, i.e., 2 × $1,050, or $2,100), (Code Sec. 1(g)(1)(B)(i); Rev Proc 2014-61, 2014-47 IRB, Sec. 3.02) plus
ii. the child’s share of the “allocable parental tax” (the tax on the child’s net unearned income that would be imposed if that net unearned income were included in the parents’ return). (Code Sec. 1(g)(1)(B)(ii))
The kiddie tax rules apply to the income of any child who:
1. (a) is under age 18, regardless of whether his earned income equals more than one-half of his support; or (b) turns 18, or if a full-time student turns 19-23, before the end of the applicable year, and the child’s earned income for the tax year doesn’t exceed one-half of his support; (Code Sec. 1(g)(2)(A))
2. has at least one living parent at the close of the tax year; (Code Sec. 1(g)(2)(B))
3. doesn’t file a joint return for the tax year; (Code Sec. 1(g)(2)(C)) and
4. has over a prescribed amount of unearned income during the tax year (Reg. § 1.1(i)-1T, Q&A 1)—i.e., $2,100 for 2015.
“Support” is defined the same way as it is for purposes of the dependency deduction requirement that a qualifying child not provide more than one-half of his own support for the tax year. (Code Sec. 152(c)(1)(D)) However, any scholarships received by a student for study at an educational organization described in Code Sec. 170(b)(1)(A)(ii) are excluded in determining the total support paid for the student for the tax year. (Code Sec. 1(g)(2)(A)(ii)(II))
The definition of “student” under the dependency deduction rules also applies for purposes of the kiddie tax rules. That definition generally provides that a student is an individual who, during each of five calendar months during the calendar year in which the taxpayer’s tax year begins, is a full-time student at an educational organization. (Code Sec. 1(g)(2)(A)(ii)(I); Code Sec. 152(f)(2))
RIA observation: So, the income of children subject to the kiddie tax is taxed as follows (unless the regular tax rules produce a higher tax):…Income not in excess of the minimum basic standard deduction allowed to dependents ($1,050 in 2015), whether earned or unearned, isn’t taxed. …Earned income in excess of the minimum basic standard deduction amount allowed to dependents is taxed at the child’s own tax rates….Investment income in excess of the minimum basic standard deduction amount allowed to dependents, but not in excess of twice that amount (for 2015, investment income greater than $1,050 but not greater than $2,100) is also taxed at the child’s own tax rates….Investment income in excess of twice the minimum basic standard deduction amount allowed to dependents (for 2015, $2,100) is taxed at the rates that would apply if that income were included in the parents’ tax return. This means that— (a) to the extent the investment income is income other than net capital gain—for example, taxable interest or short-term capital gain—the investment income is taxed at the parents’ highest marginal tax rate; and (b) net capital gain (e.g., from sales and exchanges and qualified dividend income) is taxed at capital gains rates as if that gain were included in the parents’ return.
RIA illustration For 2015, Mr. and Mrs. Smith are in the 25% federal income tax bracket. The couple are the parents of a 12-year-old son, Tommy, to whom they transfer a $22,000 bond that pays 10%. Tommy therefore receives $2,200 of investment income. He has no other income. Tommy is taxed on $1,150 of taxable income—$2,200 of gross income reduced by his $1,050 standard deduction—as follows: His “net unearned income” is $100 (the excess of his interest income above $2,100). This part of his taxable income is taxed at 25%, for a tax of $25 ($100 × 25%). The rest of Tommy’s taxable income, $1,050 ($1,150 − $100), is taxed at his 10% tax rate, for a tax of $105. Tommy’s total tax is thus $130 ($25 + $105).
How to avoid the kiddie tax. Having income subject to the kiddie tax can mean that income that would otherwise be subject to no tax (because it is offset by the child’s exemptions or his standard deduction), or to a low tax rate, will be taxed at the highest rates. So, avoiding the kiddie tax can be a real tax saver. Following are some ways to avoid the tax.
Keep the child’s annual investment income at $2,100 or less. Since no portion of the taxable investment income of a child will be taxed at the parents’ tax rates under the kiddie tax rules if that income doesn’t exceed, for 2015, $2,100, keeping the child’s investment income below that amount for the year will avoid the kiddie tax. Here are some ways to do that:
… (1) Push investment income to later tax years. The kiddie tax doesn’t apply beginning on January 1 of the earlier of: a) the first year that the child is at least 19 years old by the end of that year and isn’t a full-time student during that year, or b) the year that he turns 24 years old—regardless of the amounts of his earned income or his support during that year. This means that if a family can push investment income—that would otherwise be earned by the parents or by the child in an earlier year—so that it is earned by the child in that year or any year thereafter, the family can have that income taxed at the child’s low rate.
To accomplish this, the family can:
…Buy any of the following, and retain them until the child is no longer subject to kiddie tax: a) securities and mutual funds oriented toward capital growth which produce little or no current income; b) vacant land expected to appreciate in value; c) stock, e.g., in a closely-held family business, expected to become more valuable as the family business expands, but which pays little or no cash dividends; d) tax-exempt municipal bonds and bond funds; e) U.S. Series EE bonds for which recognition of income can be deferred until the bonds mature, the bonds are cashed in, or an election to recognize income annually is made; f) annuities and/or cash-value life insurance; g) market discount bonds, which, by their nature will have a lower current yield than comparable investments (when they are sold or mature after the child is no longer subject to kiddie tax, the built-in discount will be taxed at the child’s rates).
…If the child is a beneficiary of a trust, coordinate trust income with the child’s income. The first $2,500 of trust income is taxed at the 15% rate. Also, while capital gains are usually allocated to corpus or principal and do not affect the taxation of the beneficiaries, in certain cases, a trust instrument may contain a specific authorization to the trustee to allocate realized capital gains to income in whole or in part. (See Reg. § 1.643(a)-3(a)) To avoid the kiddie tax rules, the specific authorization given to the trustee should indicate that the child is not entitled to capital gains distributions on a current basis.
… (2) Reduce investment income in other ways. Transfer parents’ moneys to qualified tuition plans (also known as 529 plans) or Coverdell education savings accounts.
Have the child provide at least one-half of his support. While postponing or reducing investment income can avoid the kiddie tax, doing those things generally won’t allow the family to take much advantage of the child’s low bracket during the year he turns 18 (or, if he is a full-time student, during the years he turns 19-23). On the other hand, making the ratio of the child’s earned income to his support be more than 1:2 during those years means that the family can take advantage of the child’s low bracket during those years.
The principal way to accomplish this is for the child to work during those years. Meeting the one-half test while being a full-time student will often mean finding a reasonably high-paying summer job or else working during the school year and/or during other breaks from school.
Parents that have businesses can hire their children and thus increase the child’s earned income. The kiddie tax rules do not contain any rules specific to this circumstance; all that is required is that the work be bona fide, that it be documented appropriately, that the child actually be paid, and that the compensation be reasonable. And, parents who hire their child to work in the family business gain other advantages besides avoiding the kiddie tax. For example, a) because the child’s pay is deductible by the business, paying the child shifts income from the parents’ high tax bracket to the child’s low bracket; and b) if the child is under a certain age, and the parents’ business is unincorporated, hiring the child can reduce the parents’ self-employment tax while not subjecting the child’s income to FICA or federal unemployment tax.
For additional information on the benefits of a parent hiring a child to work in the parent’s business, see Weekly Alert ¶ 2 05/07/2015.
Another way to meet the one-half-of-support test is to reduce the amount of support that persons other than the child provide for the child. Generally, where the child is in college, his college costs are by far the largest part of his support. Because scholarships are not considered support, increasing the amount of a child’s scholarship to cover most of his college education, and/or having him attend a less expensive school, when combined with the child using some of his own monies for his support, can result in his passing the test.
Also, since a lot of discretionary spending is involved in supporting a child, the parents can attempt to postpone that discretionary spending during the calendar year that precedes his 19th birthday (and any of the calendar years that contain his 19th-23rd birthdays and during which he is a full-time student) and/or have the child pay for these things on his own.
Avoid full-time student status for the child. While not a practical consideration for many families, for others, having the 19-23 year old child be a part-time, as opposed to a full-time, student avoids the kiddie tax in the years before the year that the child turns 24. This strategy can be practical, for example, where part-time tuition is affordable and full-time tuition isn’t, where the child is somewhat tentative about attending college, where the family wishes for the child to be active in other activities while attending college (e.g., take care of younger family members), etc. And, if it makes sense for a particular child’s and family’s situation, postponing college altogether during one or more of the age 19-23 years will avoid the kiddie tax for each such year that the child isn’t a full-time student.
Child marries and files a joint return. While the child getting married and filing a joint return isn’t a practical consideration in many cases, in appropriate circumstances it may be a way to avoid the kiddie tax (since a “child” for kiddie taxes purposes includes individuals under age 24 in certain situations, see above). A child being married and filing a joint return avoids the kiddie tax regardless of his age or the amount of his earned income.
References: For the kiddie tax, see FTC 2d/FIN ¶ A-1300; United States Tax Reporter ¶ 14.09; TaxDesk ¶ 568,300; TG ¶ 1050.