Knowing and understanding the complexities of the Internal Revenue Code (“Code”) allows estate planning practitioners to provide advice regarding potential tax consequences of a transaction while creating inventive ways to avoid or reduce that taxation. One example of that creative planning led to the enactment of the “Kiddie Tax” which was born with the overhaul of the Code in 1986. The Kiddie Tax was designed to discourage wealthier individuals from transferring investment assets to a child to utilize that child’s considerably lower tax bracket. By holding those assets in the child’s name, rather than the parent’s name, the income generated by those assets would be taxed at the child’s lower marginal rate thereby saving significant tax dollars.
As originally enacted, the Kiddie Tax applied to the investment income of a child under age 14 by imposing the parents’ marginal rate to that income, effectively limiting the benefit of transferring the investment to the child. Divorced parents and parents filing using the “married filing separately” status posed unique complications in determining the amount of tax due. The Kiddie Tax has been modified several times since its enactment, sometimes with particularly unpleasant results. In 2018 and 2019, the Kiddie Tax saw its most draconian application to date. As part of the Tax Cuts and Jobs Act of 2017, the brackets and tax rates normally applicable to estates and trusts were applied to the unearned income of children. As you can imagine, that resulted in income taxation for a child’s unearned income at rates even higher than those of the parents in some cases. That change was met with considerable backlash which led to the passage of legislation that returned the Kiddie Tax to parents’ rates. Note that families who paid the Kiddie Tax in 2018 or 2019 have the option to file an amended return and apply the parents’ rate to the child’s unearned income during those years. If you believe that this could apply to you, you should consult with a qualified advisor to determine whether you have time to amend.
In its current iteration, the Kiddie Tax applies to unearned income for any dependent under age 18 at the end of the tax year and college students aged 19-23. If a child has unearned income that exceeds $2,200, then that income will be taxed at the parents’ marginal income tax rate, rather than the child’s rate. For a child with unearned income that does not exceed $11,000, that child’s parent may elect to report the child’s unearned income directly on the parent’s Form 1040 without filing a separate return, as long as no withholdings or estimated tax prepayments have been made for the child. If, however, a child earns more than $12,400, between earned and unearned income that child needs to file their own return. Regardless of whose return reflects the unearned income, it will be taxed at the parent’s rate. For a child with both earned and unearned income, the rules become more complex. The Code creates exceptions to the Kiddie Tax for a child with earned income totaling more than half the cost of their support and for any child that uses the filing status “married filing jointly.”
Taxable interest, dividends, capital gains, taxable scholarships, income attributable to gifts from grandparents (such as inherited IRAs), and income attributable to custodial accounts established under the Uniform Gifts to Minors Act all qualify as unearned income. The Code exempts income attributable to wages, salary, tips, and self-employment from the Kiddie Tax. The tax-deferred interest earned on 529 plans and custodial 529 plan accounts are also exempt. As noted above, the Code subjects investment earnings from other custodial accounts to the Kiddie Tax; however, those investments may be converted to custodial 529 plans to take advantage of the inherent tax benefits attributable to 529 plans.
Let’s review an example to see how the Kiddie Tax works in application. Assume that Goldie established a trust for the benefit of her minor dependent daughter, Kate, in 2020, naming Kurt as Trustee. Goldie funded the trust with assets that produced $1,100 of income that year and Kate had no earned income of her own. Because the standard deduction for Kate is the greater of $1,100 or $350 plus her earned income, neither Kate nor Goldie has any income tax consequences. If we change the facts so that the income from the trust was $2,200, then the first $1,100 would be covered by the standard deduction and the $1,100 over the standard deduction would be taxed at Kate’s marginal rate. If the trust earned $2,500, then the additional $300 would be taxed at Goldie’s marginal rate, rather than Kate’s, because it exceeds the allowable $2,200 of unearned income. As this example demonstrates, the unearned income to a child impacts the parents’ tax return much more significantly than the child’s return and this occurs even if the parent truly intended to make a gift to the child.
It’s easy to overlook unearned income when considering whether to establish a trust for the benefit of a child and most often that conversation focuses on the estate and gift tax consequences, rather than potential income tax consequences. As this article makes clear, though, unearned income and the potential application of the Kiddie Tax needs to be part of the total consideration when establishing a trust for the benefit of a child. If you have concerns about the application of the Kiddie Tax to you or your children, or if you want to consider whether amending your 2018 or 2019 income tax return may result in a refund for you.