Tuesday, March 15, 2011

Understanding and planning for the kiddie tax

The kiddie tax has been around since 1986. When it was first enacted, the tax applied to children under age 14 at calendar year end. This continued for almost 20 years. For 2006 and 2007, the tax was changed to apply to children who were under age 18-years old at year-end. Changes to the age requirement were made again in 2008, which are still in effect for 2010. Under these new rules a full-time student might be subject to the kiddie tax through age 23.

What Is the Kiddie Tax?
The purpose of the kiddie tax is to prevent parents in high income tax brackets from shifting income to their lower-income tax bracket children. The kiddie tax is calculated and reported on Internal Revenue Service (IRS) form 8615 and taxes the unearned income of the child at the parent’s rate, if it is higher than the child’s. In cases where there is more than one child subject to the tax, the unearned income of other children in the family must also be considered in the calculation. With the different tax rates for qualified dividends and capital gains, these amounts also need to be recalculated. For example a child may be in the zero-tax bracket for capital gains and qualified dividends, yet their parents are in the 15 percent bracket. Net-capital gains and qualified dividends need to be calculated separately in computing the kiddie tax as they have a maximum 15 percent tax rate. This must be calculated for the parents, child and any other children of the parents who are subject to the kiddie tax.

How Does It Work?
A child must file form 8615 and be taxed on unearned income at their parent’s tax rate if all of the following conditions are met:
  • Investment income exceeds a certain dollar amount. For 2010, this is $1,900.
  • They are required to file a return.
  • At least one parent is alive at the end of the year.
  • The child does not file a joint return.
  • They are either:
    • Under age 18 at the end of the year
    • Age 18 at the end of year but their earned income was not more than one-half of their support
    • Between the ages of 19 and 23 at the end of the year and a full-time student and their earned income was not more than one half of their support.
Investment income represents most income other than earned income and includes taxable interest, dividends and capital gains.
Whether a child is required to file a return depends on how much earned and unearned income they have during the year. They are required to file a return if any of the following conditions apply for 2010:
  • Unearned income exceeds $950;
  • Earned income exceeds $5,700;
  • Total unearned and earned income exceeds the greater of $950 or earned income (up to $5,400) plus $300.
However, If the child is under 19 (24 if a full time student) as of December 31st and their only income is from interest or dividends totaling less than $9,500, the income may be reported directly on the parent’s return, using form 8814 . Although this option would prevent the need to file a return for the child it may affect the parents return in other areas. First of all, the parents may pay $95 more tax, for the $950 standard deduction on the child’s return, which would be taxed on the parent’s return at 10 percent. More importantly is the potential phase out or disallowance of various deductions on the parents return for the increase in their income due to inclusion of the child’s income. Some of these areas are student-loan interest, individual retirement account (IRA) contributions, child tax credit, education credits or making work pay credits.
When considering the child’s age at the end of the year, a birthday on January 1, does bring the child to the next age level. For example, a child born on January 1, 1987 is considered to be 24 for purposes of a 2010 return and is not subject to the kiddie tax.
If a child is filing their return before the parent’s return is finalized, estimates may be made and the return amended, if necessary upon finalization of the parent’s return.

Ways to Minimize
There are several planning tools that may be used by taxpayers who have unearned income that could trigger the kiddie tax.
If a child between the age of 18 and 23 has earned income that is more than one half of their support, they are not subject to the kiddie tax. Support includes all amounts spent on food, lodging, clothing, medical expenses, education, recreation, transportation and similar necessities. Student loans in the name of the student are also considered to be support for which the child pays. However, if a child receives a scholarship, it is not considered support. With some planning, earned income could be maximized to be greater than half of the child’s support, whether or not it is used for the support. This includes reasonable wages that self-employed parents pay to the student for services he or she performs.
Amounts subject to kiddie tax cannot exceed taxable income. A contribution to an IRA by a child who has earned income could reduce taxable income and thereby reduce or eliminate the kiddie tax.
The education credits may be used by some students to offset the kiddie tax. This is only the case when the parent cannot claim a student as a dependent.
Students could invest in tax-free investments, including section 529 plans, which are not included in income.

The kiddie tax provides for taxing unearned income of children at their parent’s higher tax brackets. There are options related to reporting this income that taxpayers and preparers should be aware of, along with tax-planning options to reduce the kiddie tax.