Observations and Planning Implications for the New Kiddie Tax Rules under the TCJA

August 26, 2019

Observations and Planning Implications for the New Kiddie Tax Rules under the TCJA

Written by Andrew Brajcich, JD, LLM, CPA & Gerhard Barone, PhD

Abstract:

The Tax Cuts and Jobs Act changed the calculation of the tax on the unearned income of children, commonly referred to as the Kiddie Tax. Many commentators have described the changes as simply using the estate and trust income tax rate schedules instead of the parent’s marginal rate, as previous law required. While accurate, this characterization is not complete. Adjustments for “earned taxable income” are made to estate and trust tax rate schedule and the resulting tax rate schedule is used to determine the tax liability on all income of the child. This paper illustrates the new calculation and concludes that the new rules are not a simplification of prior law, but do provide for additional tax savings when shifting smaller sums of unearned income to a child. It also identifies potential tax traps for the unwary.

Article:

Changes to the computation of tax on the unearned income of children, commonly referred to as the Kiddie Tax, is one of many in the 2017 Tax Cuts and Jobs Act (TCJA). The changes have been characterized as a simplification of the calculation that use the tax rate schedules for estates and trusts instead of the marginal tax rate of the child’s parents, which prior law mandated. The calculation under the new rules, however, can be more involved than one might expect. This article illustrates how the Kiddie Tax is calculated under the new IRC §1(j)(4) and provides observations of the new legislation, including tax traps an unwitting taxpayer may encounter.

A review of the policy behind the Kiddie Tax is first in order. The Kiddie Tax aims to limit a taxpayer’s ability to shift investment income to their minor children, who are likely taxed at a lower marginal rate. Generally, unearned income is income other than compensation and certain trade or business income.[1] The following example illustrates the potential of shifting income in the absence of the Kiddie Tax rules.

Walter receives $10,000 in interest income annually and has a marginal tax rate of 39.6%. His dependent son, Casey, age 15, has a 10% marginal tax rate and earns $6,000 in wages during the summer. In 2017, Walter gifts the bonds that produce the interest income to Casey. Ignoring any gift tax and net investment income tax implications, Walter’s family saves $2,966 in regular income tax.

Tax on $10,000 interest at Walter’s marginal rate,
  $10,000 @ 39.6% = $3,960  
     

Tax on $10,000 interest on Casey’s return,[2]

  Wages                                   $   6,000
  Interest   10,000  
  AGI    16,000     
  Standard Deduction <  6,350>[3] 
  Taxable Income $  9,650
  Tax

$     994[4]

Regular Income Tax Savings of $2,966 ($3,960 less $994).


The potential for tax savings could become quite significant as parents shift more unearned income to their children over time. Enter the Kiddie Tax. Prior to 2018, the Kiddie Tax provisions taxed the unearned income of minor children in excess of a minimum $2,100 at their parents’ marginal rates.[5] This eliminated the potential of shifting large amounts of passive income to a lower-taxed return. The Kiddie Tax applies to children under the age of 18, or if a full-time student, under the age of 24. For children above the age of 17, the Kiddie Tax only applies if the child’s earned income does not exceed one-half of her support.[6] The child need not be claimed as dependent as is the case in the example above, both parents must be living, and the child cannot be filing a joint return.[7] These rules remain unchanged by the TCJA and are in effect under current law.

Using the above example but this time applying the Pre-TCJA Kiddie Tax rules, one can see how some of the tax benefit is eliminated for Walter’s family. The rules specifically affects Casey’s tax calculation.

 

Casey’s Return     Casey’s Net Unearned Income
  Wages $   6,000   Interest  $10,000
  Interest  10,000    Statutory Deduction <  1,050>
  AGI 16,000   Standard Deduction  <  1,050>
  Standard Deduction <6,350>    Net Unearned Income $  7,900
  Taxable Income $  9,650      
           
           
Tax on Casey’s 2017 return,      
   $7,900 at Walter’s marginal rate of 39.6%   $3,128  
  $1,750 of Casey’s remaining income at Casey’s rates        175  
    $3,303  


The tax savings for Walter’s family is now only $657 as compared to $2,966 without the Kiddie Tax. The Kiddie Tax, i.e., the tax on Casey’s income that is subject to Walter’s marginal rate, is generally calculated on Form 8615 and paid on the child’s return, however, a parent may elect to have the net unearned income of a child included on her return using Form 8814.

The first hazard under the Kiddie Tax is the definition of unearned income. While it includes the usual suspects of interest, dividends, capital gains, capital gain distributions, rents, royalties, and pensions and annuities, it also includes less often thought of items of income such as social security benefits, taxable scholarships, alimony, unemployment compensation, and income received from certain trusts. [8] Taxpayers are well advised to be aware of all income items subject to the Kiddie Tax provision.

The TCJA changed the calculation of the Kiddie Tax. Instead of computing the child’s tax using the parents’ rates, the new calculation for tax years 2018 through 2025 uses the estate and trust tax rates with modifications that may vary among taxpayers. To illustrate, let us first look at the applicable table for 2018.

2018 Estates and Trusts Tax Rates[9]

 

 

If taxable income is over But not over The tax is Of the amount over
$0 $2,550 $0.00 + 10%   $0
$2,550 $9,150 $255.00 + 24% $2,550
$9,150  $12,500 $1,839.00 + 35%  $9,150
$12,500   ---  $3,011.50 + 37%  $12,500

 

For the Kiddie Tax calculation, IRC §1(j)(4) provides for the construction of a table similar to the one above. Each tax rate (10%, 24%, 35% and 37%) will have a threshold equal to the threshold seen above ($2,550, $9,150, and $12,500) plus the child’s earned taxable income. Earned taxable income is a new concept specific to the Kiddie Tax. It is defined as taxable income less net unearned income, two terms that pre-date the TCJA and remain unchanged by it. All of the child’s income is then applied to the newly constructed tax rate schedule.

Building on our example of Walter and Casey and using the new law, one can determine Casey’s tax liability for 2018, assuming again that he has $6,000 from a summer job, $10,000 in interest, and no other income.

 

 

   Casey’s Return                                                          Casey’s Net Unearned Income

Wages                       $   6,000                         Interest                                    $10,000

Interest                        10,000                         Statutory Deduction                <  1,050>

AGI                              16,000                         Standard Deduction                <  1,050>

Standard Deduction    <6,350>[10]                    Net Unearned Income             $  7,900

Taxable Income          $  9,650

Casey’s earned taxable income is $1,750 ($9,650 less $7,900). Another way to determine the earned taxable income when net unearned income is greater than zero is the following formula.

                        Earned income – (standard deduction – 2,100)

                        $6,000 – $(6,350 – $2,100) = $1,750[11]

The thresholds in Casey’s tax bracket are determined by adding his earned taxable income of $1,750 to the thresholds applicable to estates and trust for the year. Casey’s tax on taxable income of $9,650 is then determined as follows,

            10%: 0 to $4,300 ($2,550 + $1,750):                                                  $   430

24%: $4,301 to $10,900 ($9,150 + $1,750):                                       $1,284

35%: $10,901 to $14,250 ($12,500 + $1,750)            :                                            -  

37%: $14,251 and above:                                                                           - 

                                                                                                Total:               $1,714

 

When compared to the prior year 2017 pre-TCJA Kiddie tax rules, Walter’s family will have tax savings of $1,589 ($3,303 less $1,714).[12] In 2018, Walter’s tax on the $10,000 interest had he not gifted the bonds to Casey would be $3,700 ($10,000 at 37%), assuming he is again in the highest tax bracket and not accounting for the net investment income tax. The shifting of income to Casey’s return provides a $1,986 ($3,700 less $1,714) in 2018, or 53% savings.

The Kiddie Tax under the new rules is not as costly as it was previously when shifting smaller amounts of unearned income to a child. Therefore, the opportunity to save on taxes for taxpayers similarly situated to Walter has increased. This result seems equitable since most taxpayers who unknowingly are snared in the Kiddie Tax trap are not attempting to shift large amounts of income to a child; rather, they may be doing something as simple as teaching a child the life lesson of saving and investing.

What does the Kiddie Tax calculation look for the shifting of larger amounts of unearned income? Let us now assume Casey has $50,000 in interest in 2018 in addition to summer wages of $20,000.

   Casey’s Return                                              Casey’s Net Unearned Income

Wages                       $  20,000                        Interest                                    $50,000

Interest                        50,000                         Statutory Deduction                <  1,050>

AGI                              70,000                         Standard Deduction                <  1,050>

Standard Deduction   <12,000>[13]                   Net Unearned Income             $ 47,900

Taxable Income          $ 58,000

Casey’s earned taxable income is $10,100 ($58,000 less $47,900). Alternatively, using the formula above, Casey’s earned taxable income of $10,100 can be determined

                        Earned Income – (Standard Deduction – 2,100)

 

                        $20,000 – ($12,000 – $2,100) = $10,100

The thresholds in Casey’s tax bracket are determined by adding his earned taxable income of $10,100 to the thresholds applicable to estates and trust for the year. Casey’s tax on taxable income of $58,000 is then determined as follows,

            10%: 0 to $12,650 ($2,550 + $10,100):                                              $  1,265

24%: $12,651 to $19,250 ($9,150 + $10,100):                                   $  1,584

35%: $19,251 to $22,600 ($12,500 + $10,100):                                 $  1,173

37%: $22,601 and above:                                                                  $13,098 

                                                                                                Total:               $17,120 

Compared to the tax on Walter’s return of $18,500 ($50,000 interest income at 37%), the tax savings are $1,301 ($18,500 less $17,199), or 7% savings. Therefore, the opportunity for tax savings decreases as more unearned income is shifted to a child. This result is consistent with the principles of vertical equity and the progressive tax rate structure in the U.S.

The effect of the new Kiddie Tax brackets is to tax earned income first and then tax unearned income at the child’s marginal rates, which are compressed for this calculation. For planning purposes, advisors should then look to the child’s marginal rates in the context of adjusted estate and trust income tax rates. Since the new calculation contains more moving parts than prior law, planning could be more complex and less accurate. Shifting of income between family members remains a viable strategy when a child is between the ages of 18 to 23 as the Kiddie Tax is not applicable unless the child has earned income in excess of 50% of her support. Further, children 24 and above are not subject to the Kiddie Tax.

Many parents may wish to gift assets to their children for reasons other than tax savings only to be surprised by an additional tax bill under the Kiddie Tax. These taxpayers are well advised to consider the use of statutory vehicles, e.g., 529 plan, if applicable to their circumstances, in an effort to avoid the potential tax trap for the unwary.

 

The TCJA Kiddie Tax rules provide for a more involved calculation of the taxable liability for certain children with unearned income. The calculation uses the estate and trust income tax rate schedules with modification for “earned taxable income” to determine the tax on all of the child’s unearned income. Earned taxable income can be determined by decreasing earned income by the standard deduction reduced by $2,100 when the child has net unearned income. The new Kiddie Tax rules still provide for savings when a child has smaller amounts of unearned income, however, this benefit declines as the child’s unearned income rises.  

In response to criticism that the new Kiddie Tax rules unfairly burden low-income students receiving scholarships and children receiving military survivor benefits, on May 23, 2019 the House of Representatives passed legislation to repeal the TCJA changes to the Kiddie Tax.[14] A similar Senate bill repeals the TCJA changes for Gold Star families.[15] What is next for the Kiddie Tax remains to be seen as legislation moves through each chamber of Congress.

 

Biography of Authors

Andrew Brajcich, JD, LLM, CPA* is an associate professor of accounting at Gonzaga University in Spokane, WA. Prior to joining academia, Andrew worked in the International Tax Services Group at Deloitte Tax LLP. His research is focused on international, individual, and S corporation tax. He teaches continuing education throughout the country for various organizations and serves on the International Tax Committee of the Washington Society of CPAs.

Gerhard Barone, PhD is an associate professor of accounting at Gonzaga University in Spokane, WA. Prior to joining academia, Gerhard worked in Audit & Assurance at Deloitte LLP.  His research focuses on various quality and guidance issues in accounting.  At Gonzaga, Gerhard primarily teaches financial accounting and financial statement analysis courses.

 

[1] IRC §1(g)(4) defines unearned income as income that is not earned as defined in IRC §911(d)(4).

[2] Note that without the interest, Casey would have no tax liability due to his standard deduction.

[3] The standard deduction for a taxpayer claimed as a dependent on another taxpayer’s return is the greater of earned income (here, $6,000 in wages) plus $350, or $1,050. In no event may the dependent’s standard deduction be greater than the statutory standard deduction available for single taxpayers found in IRC §63. In 2017, the standard deduction of a single taxpayer was $6,350. Here, the standard deduction for Casey as a dependent is also $6,350: $6,000 plus $350.

[4] Computed using the 2017 Tax Rate Schedules. Using the 2017 1040 Tax Tables would yield a tax liability of $985.

[5] The $2,100 figure is composed of a statutory deduction of $1,050 and the greater of the minimum standard deduction of $1,050 available for dependent taxpayers or the child’s itemized deductions. IRC §63(c)(5)(A). IRC § 1(g)(4)(A)(ii).

[6] IRC §1(g)(2).

[7] Id.

[8] See footnote 1 above. IRC §911(d)(4) defines earned income as “wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered…”

[9] This schedule was compressed under the Revenue Reconciliation Act of 1993. Prior to that Act, estates and trusts used the single taxpayer rate schedule, which provided for the opportunity to shift income to multiple returns (Forms 1040 and 1041) and make multiple use of the lower graduated rates. The 1993 changes were in response to this tactic. 

[10] While the standard deduction for most taxpayers has increased under the TCJA, the standard deduction for a taxpayer claimed as a dependent remains the greater of earned income (here, $6,000 in wages) plus $350, or $1,050.

[11] This formula holds true when the minimum standard deduction for a dependent is used. Assume Casey has only $500 in summer wages.

 

Casey’s Return                                                     Casey’s Net Unearned Income

Wages                                 $     500                     Interest                                                  $10,000

Interest                                  10,000                   Statutory Deduction                           <  1,050>

AGI                                          10,500                   Standard Deduction                            <  1,050>

Standard Deduction            <1,050>                 Net Unearned Income                        $  7,900

Taxable Income                    $ 9,450

 

 

Casey’s earned taxable income is $1,550 ($9,450 less $7,900). Alternatively, using the formula above, Casey’s earned taxable income of $1,550 can be determined

 

                                Earned Income – (Standard Deduction – 2,100)

 

                                $500 – ($1,050 – $2,100) = $1,550

[12] The authors acknowledge this is not a like-for-like comparison given the calculations involve different tax years amidst major tax legislation.

[13] Casey’s standard deduction as a dependent in 2018 is the greater of earned income (here, $20,000 in wages) plus $350, or $1,050, but not greater than $12,000.

[14] H.R.1994 - Setting Every Community Up for Retirement Enhancement Act of 2019 (“The SECURE Act”).

[15] S.1370 - Gold Star Family Tax Relief Act.

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