Kiddie Tax

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. For 2010, any investment income greater than $1,900 will be taxed at the parent's tax rate instead of the child's tax rate and the standard deduction for investment income is $950. If the child's investment income is greater than $950 but less than or equal to $1,900, then the child pays a tax based on his own rate. 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 must be less than 14, but Congress increased that limit, so any child claimed as a dependent who is less than 19, or 24 if the child is a full-time student, may be subject to the kiddie tax.

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 $1,900, since the applicable parent's tax rate applies only to the amount exceeding $1,900. Unearned income also includes income from a trust unless it is a qualified disability trust.

The kiddie tax does not apply to children who file a joint return.

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 Investment Income Greater Than $1900. 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 Return 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. 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, the parent who had custody of the child for most of the year, is considered to be 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.

Calculating and Reporting the Child's Tax by Filing Form 8615

If the parent does not include the child's income on his 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:

1. Determine the child's net unearned income. If it is less than $1,900, then the income is not subject to the kiddie tax.
2. Determine the allocable parental tax, which is the tax on 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 $1,900, then the child's tax rate is applied to the income, 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 $1,900) - 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.

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 these additional requirements are met:

• The child's income is greater than $950 but less than $9,500.
• 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 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 $950 but less than or equal to $1900, even if the tax would otherwise be zero 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.
• Deductions for the parent may be reduced for itemized deductions that are subject to the 2% AGI floor and medical deductions subject to 7.5% AGI floor. IRA contributions may be reduced if phaseout rules apply.
• 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 or dividends, 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.

The qualifying parent can make the election to include the child's income on his own return by attaching Form 8814 to his income tax return, and including this income on the Other Income line of the Income section of Form 1040.

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, which in 2011, will be $5,800, 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 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.