Once upon a time, parents used a strategy to save taxes on investment income by transferring the income producing assets to their children, to take advantage of their standard deduction and much lower tax brackets. To prevent this, Congress passed the so-called kiddie tax, which taxes the investment income of children that is above a certain amount at the parents' highest tax rate and reduces the standard deduction for investment income. Any investment income greater than the kiddie tax exemption will be taxed at the parent's tax rate instead of the child's tax rate, unless both parents are dead, in which case the child's tax rate will apply. If the child's investment income is greater than the kiddie tax standard deduction for investment income (2014: $1,000), but less than or equal to kiddie tax exemption (2014: $2,000), then the child pays a tax based on his own rate, which is 10%. Likewise, the child applies his own tax rate to earned income.
General Requirements of the Kiddie Tax
For the tax to apply, the child must satisfy the kiddie tax age requirements at the end of the tax year. Originally, the age requirement was that the child be younger than 14, but Congress increased that limit, so any child claimed as a dependent who is younger than 19, or 24 if the child is a full-time student, may be subject to the kiddie tax. However, the kiddie tax does not apply to children who file a joint return.
Another requirement is that the child must have had unearned income — from interest, dividends, or capital gains distributions, taxable pension payments, rents, royalties, or income from custodial accounts or property, even if the property was purchased with a child's wages or given as a gift, or any other income not earned by working — greater than $2,000, since the applicable parent's tax rate applies only to the amount exceeding $2,000. Unearned income also includes income from a trust unless it is a qualified disability trust.
The law provides 2 methods to calculate and report the kiddie tax. One method is to report the child's income on his own return, by filing Form 8615, Tax For Certain Children Who Have Unearned Income. The other method is to include the child's income on the parents return by filing Form 8814, Parents' Election to Report Child's Interest and Dividends.
Which Parent's Tax Rate Must be Used?
However, regardless of which method is used, the tax is calculated by using the tax return of the parent, custodial parent, or stepparent with the highest taxable income, which I will call, for lack of a better term, the kiddie-tax parent. If a joint return is filed, then obviously that return is used, but if the parents file separately, then the parents do not have a choice in which return to use:
- For married parents, whether living together or separately, or if the parents were never married but lived together all year, then the return with the greater taxable income must be used.
- If married parents are living separately and the custodial parent — which is the parent who had custody of the child for most of the year — is considered the head of the household, or the parents are divorced or legally separated, then the return of the custodial parent must be used.
- If the custodial parent has remarried, then the return with the greatest income of either the custodial parent or stepparent must be used.
The kiddie tax computation does not affect the parent's tax liability nor does it affect any income limitations on deductions or credits, unless the parent chooses to report the child's investment income on her own return.
Calculating and Reporting the Child's Tax by Filing Form 8615
If the parent does not include the child's income on her own tax return, then Form 8615 must be filed for the child if at least one parent was alive at the end of the tax year and the child is required to file.
Use the following steps to calculate the kiddie tax liability of the child:
- Determine the child's net unearned income. If it is less than the exemption, then the income is not subject to the kiddie tax.
- Determine the allocable parental tax, which is the tax on the net unearned income subject to the parent's rate.
The child's net unearned income is calculated by subtracting the greater of the standard deduction or itemized expenses from the child's gross income.
Child's Net Unearned Income = Gross Unearned Income - (Greater of Standard Deduction or Itemized Deductions)
If the net unearned income is less than or equal to the kiddie tax exemption of $2,000, then the child's tax rate is applied to the income above the standard deduction, which is included on his own Form 1040 or 1040A.
Child's Income Subject to Child's Tax Rate = (Lesser of Net Unearned Income or Kiddie Tax Exemption) - Investment Standard Deduction
To determine the allocable parental tax, the parent with the highest taxable income must first determine her tax liability on her income. Then the parent must add the net unearned income of all of her children to her own income to determine the tentative tax liability. The difference between the taxes on the 2 incomes is the allocable parental tax that must be added to any other taxes that the child may owe to determine the child's total tax liability.
Allocable Parental Tax = Tax on (Parent's Income + All Children's Net Unearned Income Subject to the Kiddie Tax) - Tax on Parent's Income
If there is more than 1 child subject to the kiddie tax, then the net investment income of each child is divided by the sum of the net investment income of all children who are subject to the kiddie tax to determine their proportion of the tax liability.
|Tax Liability on|
for Each Child
|= Allocable Parental Tax ×||Child's Net Unearned Income|
Total Net Unearned Income of All Children
Example - Allocating Kiddie Tax Liability
- Net Unearned Income = Total Unearned Income - Greater of (Standard Deduction or Investment Expenses)
Robert has net unearned income of $7,000 and Christine has net unearned income of $3,000 that is subject to the kiddie tax.
- Total net unearned income of children = $7,000 + $3,000 = $10,000
- Robert's percentage of the parental tax = $7,000 / $10,000 = 7/10 = .7 = 70%
- Christine's percentage = $3,000 / $10,000 = 3/10 = .3 = 30%
- Therefore, if the parent's tax was increased by $1000 because of the added income from the children, then Robert would add $700 to his tax on his Form 8615, and Christine would add $300 on her form.
|2015 - 2016||$1,050||$2,100|
|2013 - 2014||$1,000||$2,000|
|2010 - 2012||$950||$1,900|
If the child also has earned income, then:
- Standard Deduction = Greater of $1,000 or Earned Income + $350, up to the standard deduction for earnings.
- If a child has both earnings + investment income, then the minimum standard deduction is $1000, if earnings are ≤ $650; if earnings exceeds $650, then the standard deduction = standard deduction for earnings + $350, but only if the total is less than the standard deduction for earnings; otherwise, the standard deduction for earnings applies.
- If a child has itemized deductions for expenses that are directly connected to the production or collection of income or to manage income-producing property, then the amount by which it exceeds 2% of the child's adjusted gross income (AGI) can be subtracted from the investment income, in addition to the standard deduction, but only if itemized deductions + investment standard deduction > $2,000.
- A child who files Form 8615 may be liable for the alternative minimum tax (AMT) if some income comes from accelerated depreciation, tax-exempt interest from private activity bonds, passive activity losses, certain distributions from estates or trusts, or from other preference items under the AMT tax system. In such cases, the AMT exemption amount is much lower for the child than it is for other taxpayers. For instance, in 2015, the AMT exemption amount is limited to the child's earned income + $7400, while the exemption amount for other single taxpayers is $53,600.
- In the unlikelihood that the child's tax rate is higher than the highest parental rate — e.g., the child is a movie star — then the child's tax rate will apply, since Form 8615 selects the higher tax between the tax calculated without the kiddie tax and with the kiddie tax.
- A child's investment income may also be subject to the net investment income tax (NIIT), the 3.8% Medicare tax assessed on investment income exceeding the NIIT income threshold of $200,000.
Deductible Itemized Expenses = Total Itemized Expenses – (AGI × 2%) – Investment Standard Deduction
Net Investment Income = Investment Income – Kiddie Tax Exemption – Deductible Itemized Expenses
Kiddie Tax = Net Investment Income × Parent's Highest Marginal Rate
Child's Tax = [Lesser of (Investment Income or Kiddie Tax Exemption) – Investment Standard Deduction] × 10%
Total Tax = Kiddie Tax + Child's Tax
Examples: Calculating the Kiddie Tax when the Child has Both Earnings from Work and Investment Income
- Standard Deduction for Earnings = $6200
- Standard Deduction for a Dependent with only Unearned Income or Earned Income ≤ $650 + Unearned Income = $1000
- If a Dependent has Both Earnings + Unearned Income, then:
- Standard Deduction = Lesser of (Earnings + Unearned Income) or Standard Deduction for Earnings
- Earnings = $5700
- Investment Income = $300
- Tax Calculation:
- Standard Deduction = $5700 + $300 = $6000
- Since $6000 is less than or equal to the lesser of the standard deduction of $6200 or earnings + $350, there is no taxable income.
- Earnings = $5700
- Investment Income = $600
- Tax Calculation:
- Total Income = $5700 + $600 = $6300
- Standard Deduction = $5700 + $350 = $6050
- Taxable Income = $5700 + $600 – $6050 = $250
- Tax = $250 × 10% = $250
- Earnings = $6000
- Investment Income = $500
- Tax Calculation:
- Total Income = $6000 + $500 = $6500
- Standard Deduction = Standard Deduction for Earnings = $6200
- Standard Deduction = Lesser of (Earnings + $350) or Standard Deduction for Earnings
- Taxable Income = $6500 – $6200 = $300
- Tax = $300 × 10% = $30
- Earnings = $0
- Investment Income = $7000
- Top Marginal Tax Rate for Parents = 25%
- Tax Calculation
- Child's Taxable Income Subject to Child's Tax Rate = $2,000 – $1000 = $1000
- Child's Tax = $1000 × 10% = $100
- Kiddie Tax = ($7000 – $2000) × 25% = $1250
- Total Tax Reported on Form 8615 = Child's Tax + Kiddie Tax = $100 + $1250 = $1350
- Earnings = $10,200
- Investment Income = $5000
- Total Income = $15,200
- Top Marginal Rate for Parents = 25%
- Tax Calculation
- Taxable Income = Total Income – Standard Deduction = $15,200 – $6200 = $9000
- Taxable Income from Work = Taxable Income – Investment Income = $9000 – $5000 = $4000
- Income Subject to Kiddie Tax = Investment Income – Kiddie Tax Exemption = $5000 – $2000 = $3000
- Total Income Subject to Child's Tax = Taxable Earnings + Investment Income – Investment Income Subject to Kiddie Tax = $4000 + $5000 – $3000 = $6000
- Total Tax = Child's Tax + Kiddie Tax = ($6000 × 10%) + ($3000 × 25%) = $600 + $750 = $1350
Summary of Rules for Your Child Filing Form 8615
You may use Form 8615, Tax For Certain Children Who Have Unearned Income to figure your child's tax if all of the following are true:
- The child's unearned income was greater than $2100.
- The child is required to file a tax return.
- The child was:
- younger than age 18 at the end of the tax year
- was younger than 24 and a full-time student, or
- was 18 at year end but whose earned income did not exceed ½ of her support.
- The child had at least 1 parent alive at the end of the tax year.
- The child is not filing a joint return.
Even if all of the above is true, you still have the option of including your child's income on your own return by filing Form 8814, Parents' Election to Report Child's Interest and Dividends, but if any of the above is not true, then Form 8615 cannot be used.
A child who files Form 8615, Tax For Certain Children Who Have Unearned Income may also be liable for the alternative minimum tax (AMT) if some income comes from accelerated depreciation, tax-exempt interest from private activity bonds, passive activity losses, certain distributions from estates or trusts, or from other preference items under the AMT tax system. In such cases, the AMT exemption amount may be much lower for the child than it is for other taxpayers. For instance, in 2015, the AMT exemption amount is limited to the lesser of the child's earned income + $7400 or $53,600, while the exemption amount for other single taxpayers is $53,600.
Reporting the Child's Income on the Parent's Return
If the child's investment income consists of only interest and dividends, including capital distributions from mutual funds or Alaska Permanent Fund dividends, then the parent with the highest taxable income can elect to report the child's income on her own return if the child's income is greater than the standard deduction but less than 10 times that amount. Additional requirements are that the child was not subject to backup withholding for the tax year, and no estimated tax payments were made under the child's social security number, including overpayments from the previous year. This requirement probably results from the fact that the IRS has no provision for transferring tax payments made under one social security number to another. The qualifying parent can make the election to include the child's income on his own return by attaching Form 8814, Parents' Election to Report Child's Interest and Dividends to his income tax return, and including this income on the Other Income line of the Income section of Form 1040. The calculations on Form 8814 uses the preferential tax rates for qualified dividends and long-term capital gains, if the child has any. However, the portion of qualified dividends and long-term capital gains greater than $1000 but less than $2000 may be taxed at 10%, whereas if the child filed a separate return, these preferential gains would probably not be taxed at all, because the 0% rate would probably apply.
|2015 - 2016||$1,050||$10,500|
|2013 - 2014||$1,000||$10,000|
|2010 - 2012||$950||$9,500|
The main advantage to reporting the child's income on the parent's tax return is that it eliminates the need for the child to file his own return. There may also be some minor advantages for the parent, such as being able to offset more investment interest with a higher investment income, and the charitable donation ceiling may also be increased. However, there are several disadvantages to making this election:
- The parent will have to pay a 10% tax on the income that is greater than the investment standard deduction but less than or equal to kiddie tax exemption of $2,000, even if the 0% rate would otherwise apply because it consisted of qualified dividends or capital gains distributions.
- A higher tax rate may be applied to the income subjected to the allocable parental tax.
- The investment income may be subject to the additional 3.8% Medicare tax if the parent's income is high enough.
- Deductions for the parent may be reduced for itemized deductions that are subject to an AGI floor, such as the 2% AGI floor that applies to job expenses and other miscellaneous itemized deductions and the higher AGI floor for medical deductions and casualty and theft losses.
- The increased income may reduce other deductions or tax advantages by making it more likely that phaseout rules will apply, such as those for claiming personal and dependency exemptions or for making IRA contributions, or reducing the reduction for student loan interest.
- The earned income credit, child tax credit, dependent care credit, and educational tax credits may be reduced because of the higher income.
- The $25,000 rental loss allowance that is allowable under passive activity rules may be reduced.
- Deductions that cannot be taken include the standard deduction for a blind child, a deduction for the early withdrawal penalty of a child's savings, and any itemized deductions, such as the child's investment expenses or charitable contributions.
- If the child received tax-exempt interest from private activity bonds or other preference items, it may be a tax preference item for the parent for alternative minimum tax purposes.
- State and local income tax liability will probably be increased.
Summary of Rules for Including Your Child's Income on Your Tax Return
- At the end of the tax year your child was younger than 19 or younger than 24 and a full-time student.
- Your child's only income was interest and dividends, including capital gains distributions.
- Your child's income was less than $10,500.
- Your child would be required to file a tax return if you choose not to include his income on your return.
- You are the kiddie-tax parent, who is usually the one with the highest taxable income.
- Your child will not be filing a joint return and did not:
- pay estimated taxes for the tax year;
- had federal income tax withheld; or
- applied an overpayment of tax from the previous year.
If any of the above is not true, then you cannot include your child's income on your return; otherwise you can file Form 8814, Parents' Election to Report Child's Interest and Dividends with your return.
Circumventing the Kiddie Tax
In spite of the kiddie tax, there are some ways to shelter some income using your children. You can purchase United States Savings Bonds or growth stock for the child. If the bonds are redeemed or the growth stock is sold when the kiddie tax no longer applies, then the applicable tax rate will be the child's lower rate.
If the parents have a business, they can employ their child, which will allow them to write off the wages as a business deduction and the tax on the child's income will be minimized by the child's standard deduction and applicable tax rate, since the kiddie tax does not apply to unearned income. Furthermore, the business does not have to pay Federal Insurance Contributions Act (FICA) taxes (Social Security and Medicare taxes) nor Federal Unemployment Tax Act (FUTA) taxes if the child is under 18. And the child can contribute up to $5,000 of the earnings to an IRA account to begin retirement savings.