The Tax Reform Act of 1986 created the kiddie tax as a way to prevent parents from shifting investment income to children in order to cut the overall tax bill for the family. Over the years, the kiddie tax has undergone some changes, most notably in the age to which it applies. The Tax Cuts and Jobs Act of 2017 (TCJA) dramatically changed the way in which the tax is computed.

Overview

The kiddie tax is not a separate tax, but rather a method of computing tax on a child's unearned income over a threshold amount (Code §1(g)). The source of the unearned income (e.g., as a gift from a parent or grandparent or as an investment of a child's earned income) is irrelevant.

The kiddie tax applies for a child with a living parent and who is under age 18 at the end of the year, age 18 but less than 19 and earned income that does not exceed half of his or her support, or age 19 but under 24 and a full-time student. It does not include a child who files a joint return with another taxpayer. The definition of a child for purposes of the kiddie tax has not been changed by the TCJA.

Unearned income means dividends, interest income, capital gains (including capital gain distributions), rents, royalties, unemployment compensation, and the taxable portion of distributions from retirement plans and annuities as well as the taxable portion of Social Security benefits. And it includes distributions of unearned income from a trust in which the child is a beneficiary.

Figuring Tax

If a child has earned income from a job or self-employment, it is taxed to the child using the child's marginal tax rates for a single taxpayer. Thus, earned income in 2018 can be taxed at rates ranging from 10 percent to 37 percent. The income would be tax free up to $12,000 in 2018 (the amount of a single person's standard deduction amount).

If the child has unearned income, the way in which it is taxed has been transformed by the TCJA. The first $2,100 of earned income in 2018 is taxed as follows: no tax on $1,050 (the standard deduction amount for a dependent child with no earned income); the next $1,050 is taxed at 10 percent. Thus, the total tax on the first $2,100 of unearned income is $105.

Unearned income over $2,100 is now taxed to the child using the tax rates applicable to trusts and estates. Instead of the seven tax rates for individuals, the child's tax is figuring using the four rates for trusts and estates. These rates are 10 percent, 24 percent, 35 percent, and 37 percent. The top tax rate applies in 2018 to taxable income over $12,500, so it's easy to attain the highest tax rate on relatively modest investment income. In contrast, a single person not subject to the kiddie tax would pay just 12 percent on the top dollars of $12,501 of taxable income.

So the first $2,100 of unearned income continues to be taxed the same as before, for a tax of $105. But if unearned income is more than $2,100, it is taxed higher than under the prior rules where the parent's top marginal rate was used to compute the child's tax.

Similarly, the favorable rate used for qualified dividends and long-term capital gains now depends on the child's taxable income. Thus, the child could easily pay a 20 percent rate on qualified dividends and long-term capital gains even though the parent is only paying 15 percent on such investment income. The threshold at which the 20 percent applies for the kiddie tax is $12,500 of taxable income, as compared with $479,000 of taxable income on a joint return.

Other Matters

A child may be subject to the alternative minimum tax (AMT). A child who is subject to the kiddie tax is ineligible to use the exemption amount applicable to single individuals ($70,300 in 2018). Instead, a special AMT exemption amount applies (Code §59(j)). For 2018, the child's AMT exemption amount is $7,600 (Rev. Proc. 2018-18, IRB 2018-10, 392). The exemption amount is increased by the child's earned income (but the total cannot exceed the exemption amount for a single person).

A child may also be subject to the net investment income (NII) tax, which is 3.8 percent on the lesser of net investment income or the excess of the child's modified adjusted gross income over $200,000.

In the past, a parent could opt to report a child's dividends, interest income, and capital gain distributions on his or her return. This may have been a good option to avoid the need to file a separate return for the child. Form 8814, Parents' Election to Report Child's Interest and Dividends, was used for this purpose; it could not be used if the child had any other type of unearned income. Of course, the child's income then counted as the parent's income, which could reduce or bar certain tax breaks based on adjusted gross income.

Now, a parent can still do the same for the same type of unearned income. As in the past, this option is limited to a child with dividends, interest income, and capital gain distributions up to $10,500. Form 8814 is still used for this purpose. But if the child's unearned income is greater than $10,500, the parent cannot opt to report it on his or her return; the child must file his or her own return. And if the child has any tax preference items (e.g., certain tax-free interest on private activity bonds), they are taken into account on the parent's return for AMT purposes.

Conclusion

The kiddie tax may not be a significant issue for many families. As before, wealthy families will likely continue to shift income—directly or through trusts—not only as a means of tax savings but for other purposes (e.g., asset protection, succession planning). Of the more than 9.3 million returns filed by dependents in 2016, only 265,500 dependents reported the kiddie tax (https://www.irs.gov/statistics/soi-tax-stats-individual-statistical-tables-by-size-of-adjusted-gross-income). But it continues to be a feature with which families must deal. The TCJA made it easier to figure the kiddie tax because it is no longer necessary to know the marginal rates of the child's parent. But for many of those subject to the kiddie tax, it has raised the amount of taxes that will be paid on unearned income.

Sidney Kess, CPA-attorney, is of counsel at Kostelanetz & Fink and senior consultant to Citrin Cooperman & Company.