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The Dreaded Kiddie Tax

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

July 2007
from Journal of Accountancy

This article has been excerpted from the Journal of Accountancy. Read full article with useful exhibits and practical tips here.

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 five percent, provided the child’s total income is low enough, and the higher rate of 15 percent 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 percent 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.

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 percent x $700), and Joe’s tax is $141 [(10 percent x $850) + (28 percent x $200)]. Joe’s net unearned income is taxed at his parent’s 28 percent rate. Computing the kiddie tax is more difficult when parents have more than one child subject to it. Also, parents’ living arrangement and filing status affect how the kiddie tax is applied to their children (see Exhibit 1).

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, 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 percent 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 five percent and 15 percent. 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 percent tax rate, and the other $850 ($1,650 – $800) of her taxable income is taxed at her five percent 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 percent. 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 percent ($1,800 ÷ $3,000) of the $1,300 is dividend income taxed at 15 percent, with the remaining net unearned income of $520 ($1,300 – $780) taxed at 28 percent.

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 five percent rate. Thus, Carter has $850 of taxable income taxed at five percent. 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 percent rate — $850 is taxed at her five percent rate, and $170 is taxed at her parent’s 28 percent 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)].

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.

This article has been excerpted from the Journal of Accountancy. Read full article with useful exhibits and practical tips here.

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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. They are contributing writers of the Journal of Accountancy. Their views as expressed in this article do not necessarily reflect the views of the AICPA or the Journal of Accountancy.