The kiddie tax was added by the Tax Reform Act of 1986 to help prevent wealthy taxpayers from shifting investment assets to children, who generally enjoy lower tax brackets. In its 30-plus years of existence, the kiddie tax has expanded its reach from dependents under the age of 14 to those under the age of 19 and 24, if full-time students. As a result, parents have faced increasingly more complexity when applying these rules.
Application & Filing
Since the intention of the kiddie tax is to hinder income shifting, it rightly applies to unearned income only — or income derived purely from investments. For the 2016 tax year, the first $1,050 of the dependent’s unearned income, such as from a custodial savings account, is non-taxable. The second $1,050 of unearned income is taxed at the dependent’s tax rate. Any remaining unearned income in excess of the $2,100 is taxed at the parents’ rate. Exceptions are available for married dependents filing a joint return or dependents with no living parent at year-end.
There are two filing options:
- The dependent files her own tax return. Form 8615 is required to determine the amount of tax owed and takes into account the parents’ taxable income, as well as unearned income of the parents’ other dependents subject to the kiddie tax.
- The parents report the dependent’s income on their tax return via an election made on Form 8814. Certain requirements must be met to qualify for this election:
- The dependent only has unearned income,
- The dependent’s gross income for the year is less than $10,500,
- No overpayments are being applied to the dependent’s return, and
- No estimated or withholding tax has been paid on the dependent’s behalf.
Planning Opportunities and Pitfalls
The decision to report on the parents’ tax return as opposed to filing a separate tax return for the dependent will vary based on taxpayer-specific circumstances. Below are a few considerations to keep in mind when weighing the pros and cons:
- Filing with the parent’s return simplifies the process, creating one less tax return if not otherwise required for the dependent.
- Since the deductibility of investment interest expenses is directly related to the amount of investment income, it may be to the parents’ benefit, or detriment, to report the dependent’s unearned income. Additional income would increase the parents’ adjusted gross income (AGI), which may produce either positive or negative results:
- For itemized deductions such as charitable contributions, which are limited to 50% of AGI, the increased income would be beneficial.
- On the other hand, an increased AGI would reduce any other deductions and credits subject to an AGI phase-out.
- When reporting on the parents’ tax return, Form 8814 must be used, which taxes the dependent’s first $1,050 of taxable income at 10%; while the first $1,050 of unearned income would be non-taxable on the dependent’s tax return.
Which is right for you and your family? That will depend on your specific facts and circumstances, but given the complexity of the kiddie tax, consult your tax team to determine the right strategy.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.