The Dreaded Kiddie Tax

Help your clients take some of the angst out of adolescence by managing their children’s unearned income.

BY ALLEN FORD AND HEIDI L. HYDEMAN
July 1, 2007

  

 
 

 

EXECUTIVE SUMMARY

Since 1987, taxpayers wanting to shift income to children subject to lower tax rates had to consider the kiddie tax when the children were under 14 years old. TIPRA, which became law in May 2006, made a significant change in the kiddie tax retroactive to the beginning of 2006.

Children under 18 years old are now subject to the kiddie tax if they have net unearned income.

Computing the kiddie tax is often complex, and some income normally subject to preferential tax rates, such as dividend income and net capital gain, might not be taxed at those preferential rates.

Allen Ford is the Larry D. Horner/KPMG Distinguished Professor of Accounting at the University of Kansas. Heidi L. Hydeman is a tax senior in the Kansas City, Mo., office of BKD LLP. Their e-mail addresses, respectively, are aford@ku.edu and hhydeman@bkd.com .

Can your clients put their teenagers on the payroll? Preferring earned income to unearned for their children is just one way parents are paying closer attention to how much and what kind of dollars flow to their offspring. Before the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), earnings didn’t enter the picture as often, since only children under 14 were subject to the “kiddie tax”—having to use their parents’ tax rate to compute their tax liability for net unearned income. Under TIPRA, the kiddie tax applies to children under 18 for tax years beginning after 2005, so many more taxpayers must now consider it.

[As this article went to press, President Bush had just signed legislation extending the kiddie tax beginning in tax year 2008 to 18-year-olds (19–23 if a full-time student) whose earned income does not exceed half their support.]

Arranging for children to have earned income is just the beginning. Some types of unearned income, such as qualified dividends, can still be taxed at rates as low as 5%, provided the child’s total income is low enough, and the higher rate of 15% is still often lower than the parents’ marginal rate. But—here’s where a little of the dread creeps in—the proportion of net unearned income that may receive dividend treatment is limited to the ratio of dividend income to total unearned income. Other hurdles and ways of reckoning with them include parents reporting children’s net unearned income on their own return—of course, with its own set of consequences. This article describes some computational issues including deductions available to dependents and offers planning ideas not only to lessen tax liability where possible but also to coordinate funding aims for families, including saving for college. Along the way, it offers some pointers on calculating the tax for more than one child at a time—even in today’s blended families.

COMPUTING THE TAX
If the kiddie tax applies, form 8615 is used to compute it and is attached to the child’s form 1040 or 1040A. The child’s net investment income is reported on form 8615, then combined with the taxable income of the parent (unless otherwise indicated, parent in this article also applies to married couples filing jointly—see Exhibit 1) and net investment income of the parent’s other children. Form 8615 uses the term net investment income instead of net unearned income, as used in IRC section 1(g). For purposes of this article, assume the child does not itemize deductions, at least one parent is living, and the parent’s tax rate of 28% exceeds the child’s tax rate. The parent’s rate applies only to the child’s net unearned income, which in 2007 is normally unearned income less $1,700 or, if the child itemizes deductions, the higher of $1,700 or the sum of the minimum standard deduction ($850) plus itemized deductions directly connected with the production of the unearned income.

 
If the parents are:
Kiddie tax applied to each child is determined by:
Married filing jointly
Using parents’ taxable income
Married filing separately or not married and living together the entire year
Parent with higher taxable income
Married not living together
Using the custodial parent’s taxable income
Custodial parent with stepparent
Treating stepparent as the other parent

Kate, a 12-year-old with $900 of salary income and $1,000 of interest income, has no net unearned income, and Joe, a 12-year-old with $1,900 of interest income, has $200 of net unearned income. To compute the tax for a child subject to the kiddie tax, the CPA must first determine the child’s taxable income and then determine the child’s net unearned income, which may not exceed the child’s taxable income.

Most children under 18 will probably qualify as a dependent of another taxpayer and thus are not allowed a personal exemption deduction. As a dependent, the child has a standard deduction amount of the greater of $850 or earned income plus $300, up to the regular standard deduction of $5,350. If Kate and Joe qualify as dependents of another taxpayer, Kate’s 2007 taxable income is $700 ($1,900 – $1,200), and Joe’s taxable income is $1,050 ($1,900 – $850). Kate’s tax is $70 (10% x $700), and Joe’s tax is $141 [(10% x $850) + (28% x $200)]. Joe’s net unearned income is taxed at his parent’s 28% rate. Computing the kiddie tax is more difficult when parents have more than one child subject to it (see sidebar, “More Than One Child Subject to the Kiddie Tax”). Also, parents’ living arrangement and filing status affect how the kiddie tax is applied to their children (see Exhibit 1).

 

More Than One Child Subject to the Kiddie Tax

The kiddie tax imposed on each child is that child’s pro rata share of the allocable parental tax, which is determined by adding all the children’s net unearned income to their parent’s gross income and then determining the parent’s tax. The excess of the tax calculated with the children’s net unearned income included in the parent’s gross income over the parent’s tax calculated without the children’s net unearned income is the allocable parental tax.

Example. Mr. and Mrs. Reedy have taxable income of $195,000 and two dependent children, Stella and Ryan. Stella, age 5, has interest income of $2,700, and Ryan, age 16, has interest income of $3,200. Stella has taxable income of $1,850 ($2,700 – $850) and net unearned income of $1,000 ($2,700 – $1,700); Ryan has taxable income of $2,350 ($3,200 – $850) and net unearned income of $1,500 ($3,200 – $1,700).

The Reedys’ tax on their $195,000 of taxable income is $43,592.50 [$24,972.50 + (28% x $66,500)] in 2007. With the children’s net unearned income added to the parents’ taxable income, the Reedys’ taxable income is $197,500 ($195,000 + $1,000 + $1,500). The children’s net unearned income is not considered when computing any exclusion, deduction or credit of the parents. The Reedys’ tax on $197,500 is $44,375 [($43,830.50 + (33% x $1,650)], so the allocable parental tax is $783 ($44,375 – $43,592.50). Because the addition of the net unearned income increased the Reedys’ marginal tax rate to 33%, some of the children’s net unearned income is taxed at 28% and some at 33%. Stella’s portion of the $783 of allocable parental tax is $313 (40% x $783), and her tax is $398 [(10% x $850) + $313]. Ryan’s tax is $555 [(10% x $850) + (60% x $783)].

INCLUDING CHILD’S INCOME ON PARENT’S RETURN
In some circumstances, parents may avoid having to file a separate return for a child subject to the kiddie tax by electing to include the child’s net unearned income in their gross income. Form 8814 is filed with the parent’s tax return. For the election to be available, the child’s gross income must consist only of interest, dividends or capital gain distributions and be less than $8,500, which is 10 times the minimum standard deduction amount in 2007. All of the child’s gross income must be unearned. The child must not have made estimated tax payments or had taxes withheld.

The election to include the child’s income on the parent’s return may be made only by the parent whose taxable income would be used by the child to compute the kiddie tax (see Exhibit 1). The parent includes the child’s net unearned income on his or her return as gross income, which may affect deductions, credits and phase-outs. For example, the increase in AGI might reduce the amount of child credit, medical expense deduction and deduction for exemptions. Any tax-exempt interest received by the child from a private activity bond will be a tax preference item for the parent’s alternative minimum tax. Thus, the election may result in an increase in the family’s total tax liability. However, one potential benefit is the possibility of deducting more investment interest expense, because the parent will have more net investment income. The parent’s deductions, credits and phase-outs may be affected only if the child’s net unearned income is included in the parent’s gross income; they are not affected if the child files form 8615.

If Eliza is under 18 years old, has interest income of $4,850 and is a dependent of her parent, she may file a return with a taxable income of $4,000 ($4,850 – $850); and $3,150 ($4,850 – $1,700) of her taxable income (the net unearned income) is taxed at her parent’s tax rate. However, her parent could elect to include $3,150 in his or her gross income, and Eliza would not have to file a return.

In addition to reporting the child’s net unearned income as the parent’s gross income, the parent must also pay the amount of tax Eliza would have paid at her rate if she filed her own return. Thus, the parent must pay a tax of $85, or 10% of the child’s taxable income that is not net unearned income ($850). If the parent makes the election for multiple children, net unearned income for all children subject to the kiddie tax is combined and included on the parent’s return.

CHILD’S INCOME INCLUDES QUALIFIED DIVIDENDS
The portion of net unearned income that is qualified dividend income is subject to tax rates of 5% and 15%. If Carter, a dependent child under 18 years old, has qualified dividend income of $2,500, all $800 ($2,500 – $1,700) of her net unearned income is taxed at the parent’s 15% tax rate, and the other $850 ($1,650 – $800) of her taxable income is taxed at her 5% rate.

When net unearned income consists of dividend income and other types of unearned income such as interest, computation of the kiddie tax is more difficult. If Carter has dividend income of $1,800 and interest income of $1,200, her taxable income is $2,150 ($3,000 – $850), and net unearned income is $1,300 ($3,000 – $1,700), but only a portion of the $1,300 is dividend income taxed at 15%. The ratio of dividend income to all unearned income is used to find the portion of net unearned income that is dividend income; thus 60% ($1,800 ÷ $3,000) of the $1,300 is dividend income taxed at 15%, with the remaining net unearned income of $520 ($1,300 – $780) taxed at 28%.

For the parent, net unearned income is allocated between dividend income and other unearned income, but the child does not make a similar allocation. The remaining dividend income—but not more than taxable income less net unearned income—is taxed at the child’s 5% rate. Thus, Carter has $850 of taxable income taxed at 5%. Carter’s tax is $305 [(15% x $780) + (28% x $520) + (5% x $850)].

Carter has $1,800 of dividend income, and $780 of the dividend income is taxed at her parent’s 15% rate—$850 is taxed at her 5% rate, and $170 is taxed at her parent’s 28% rate. If Carter were not subject to the kiddie tax, all of her dividend income would be taxed at preferential rates, and her tax liability would be $125 [(5% x $1,800) + (10% x $350)].

PAYING MORE THAN A MULTIMILLIONAIRE
As illustrated above, children subject to the kiddie tax may have qualified dividend income that does not receive preferential tax treatment and pay the highest marginal tax rate on dividend income, while multimillionaires pay only 15%. The unfavorable treatment may also apply to a long-term capital gain.

Note that if Carter had $3,000 of dividend income, instead of dividend income plus interest income, her taxable income and net unearned income would still be $2,150 and $1,300, respectively, but all of her income would be taxed at preferential rates—either her 5% rate or her parent’s 15% rate. Thus, a child subject to the kiddie tax has a greater preference for dividend income over interest income or other non-tax-favored investment income, compared with a child who is older than 17 and thus not subject to the kiddie tax.

The loss of preferential treatment of dividend income may not be as great if the child has earned income. For example, assume that Carter has $1,000 of earned income in addition to dividend income of $1,800 and interest income of $1,200. Because her standard deduction is earned income plus $300, her taxable income is $2,700 ($4,000 – $1,300). Net unearned income is still $1,300 ($3,000 x $1,700), and $780 (60% x $1,300) is dividend income taxed at the parent’s 15% rate. Taxable income of $1,400, including the remaining $1,020 of dividend income, is taxed at the child’s rate. Carter’s tax is $352, which is the sum of the allocable parental tax of $263 [(15% x $780) + (28% x $520)] and the tax on $1,400 using her tax rates [(5% x $1,020) + (10% x $380)]. All $1,800 of dividend income is taxed at preferential rates.

Some benefits of the preferential rates may be lost if a parent elects to report the child’s net unearned income on his or her return. If a child subject to the kiddie tax has $2,000 of dividend income in 2007, $300 ($2,000 – $1,700) is taxed at the parent’s rate of 15%, but the $850 that would otherwise be taxed on the child’s return at 5% is taxed at 10% instead. Form 8814, which is used if parents want to include their child’s interest, dividends and capital gains in their gross income, includes a note of caution that the tax may be lower if the child files a separate return.

PLANNING ISSUES
The kiddie tax does not apply to earned income, so parents with a trade or business may want to hire their dependent children to work for the family firm. In 2007, parents can pay them a salary of up to $5,350 (standard deduction), and children would have no taxable income if the salary is their only income. Parents may deduct a reasonable payment as a business expense. Children with salary income may also qualify to make contributions to a Roth IRA or a regular IRA.

Children might buy zero coupon bonds, where the interest income increases annually but is below the minimum standard deduction, which will increase with inflation adjustments. A parent could give $2,967 to a 1-year-old son to buy a $15,000 zero coupon bond that matures in 17 years and yields 10%. The original issue discount of $12,033 must be amortized, so interest income is $297 in year one, $326 in year two, $359 in year three, and so on. If the child has no other gross income, he or she will have no taxable income until interest income exceeds the minimum standard deduction, and the parent’s tax rate will not apply until interest income exceeds two times the minimum standard deduction. In year 17, interest income is $1,364, which might be less than the minimum standard deduction for that year.

With the change in the kiddie tax, taxpayers wanting to save for their children’s college education will pay more attention to section 529 plans and Coverdell Education Savings Accounts (CESAs), to which they may make non-deductible contributions, with earnings not currently taxed. None of the proceeds used to pay the designated beneficiary’s qualified education expenses is subject to tax. Proceeds from a CESA may be used to pay qualified expenses of elementary and secondary education as well as higher education.

It should still be advantageous for a taxpayer’s dependent child under age 18 to have some gross income, just not enough to have net unearned income. Gross income equal to the standard deduction is not taxed, and some of the child’s taxable income will be taxed at the child’s lower rate. Parents who shift $1,700 of dividend income in 2007 to a young child with no other income may reduce taxes paid by the family by $212 [(15% x $1,700) – (5% x $850)]. The savings is $391 [(28% x $1,700) – (10% x $850)] if the income shifted is interest income instead of dividend income.

The kiddie tax may reduce the tax advantage of gifting assets to young children, and the above-described strategies help taxpayers avoid the kiddie tax. However, there may be other costs associated with shifting assets to young children, especially for parents who transfer assets to children with the goal of paying future college expenses. The child’s ownership of assets may have a significant negative effect on the amount of financial aid available. To maximize financial aid available, it may be preferable for parents, instead of the child, to own assets. In “The Expanded ‘Kiddie Tax’ and the Financial Aid Trap” ( The Tax Adviser, Jan. 07, page 48), Alan Sumutka examines why TIPRA may have increased parents’ interest in keeping assets, compared with gifting them to their children.

» Practical Tips

Caution clients that the total family tax liability may be increased if their child’s net unearned income is included in a parent’s gross income

Advise clients that expansion of the kiddie tax to older children may significantly affect how they invest and save for their children’s education.

Children subject to the kiddie tax may have a stronger preference than other taxpayers for investment income that consists of dividends and/or long-term capital gain instead of other types of investment income that do not receive preferential treatment.


If a child is subject to the kiddie tax, the child should probably strive to have all investment income consist of qualified dividends or net long-term capital gain subject to preferential tax rates, instead of having some non-tax-favored investment income. As demonstrated above, Carter, who was subject to the kiddie tax, lost the preferential tax treatment on some of her dividend income when her gross income included interest income. The above child’s preference for having only tax—favored investment income is reduced if the child also has earned income.

As much as your clients with children might in a private moment fantasize about how much simpler life will be someday in an empty nest, as long as they have your guidance, the kiddie tax doesn’t have to be their major source of dread. After all, there’s still the request for the keys to the family car. For that, you can tell your clients, they’re on their own.

 
 
AICPA RESOURCES

Articles
“The Expanded ‘Kiddie Tax’ and the Financial Aid Trap,” The Tax Adviser, Jan. 07, page 48.

AICPA PFP Center and PFS credential
The AICPA’s Personal Financial Planning (PFP) Membership Section ( http://pfp.aicpa.org) provides knowledge and resources including the Personal Financial Specialist credential.

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