The Kiddie Tax is No Child’s Game

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As originally enacted, the Kiddie Tax applied to the investment income of a child under age 14 by imposing the parents’ marginal rate to that income, effectively limiting the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.

Create A Great Funeral Day

On Halloween, October 31, we celebrate ghosts and scary things. The spirits of the deceased are remembered on November 1 and 2, All Saints Day and All Souls Day, respectively, also known as the Day of the Dead celebration.

Yet, you might not know this October 30 is the 22nd annual Create a Great Funeral Day. Before Halloween ghosts and Day of the Dead spirits can go a-haunting, there’s usually a funeral or memorial service – the party no one wants to plan.

Confronting the idea of our own death causes uncomfortable thoughts. Rather than facing the inevitability of our dying, our culture denies death. Yet at the same time, we have this enormous celebration of scary and death-related things at Halloween.

The idea behind Create a Great Funeral Day is to consider how you would like to be remembered. By letting loved ones know how you’d like your life celebrated, the survivors’ experience can be so much easier.

Create a Great Funeral Day began in 2000, started by Stephanie West Allen. She saw her husband struggling to pull together a meaningful funeral for his mother, who had left no directions before she died. Observing his grief, Allen felt that knowing what her mother-in-law might have wanted would have eased the pain of memorial service preparations.

Why do people hesitate to discuss funeral planning, let alone do anything concrete about it in advance?

Social psychologists cite the Terror Management Theory, that all human behavior is ultimately motivated by the fear of death. Death creates anxiety, not only because it can strike at unexpected and random moments, but because its nature is essentially unknowable.

The awareness of our own eventual death, called “mortality salience,” affects our decision-making in the face of this terror. Many people decide to avoid the topic.

Create a Great Funeral Day prompts us to be mindful of our mortality. This self-awareness enables us to plan reflectively in advance, so we don’t leave our families to react disorganized and stressed, after our death.

Blue Öyster Cult’s 1976 hit song, “Don’t Fear the Reaper,” is a perennial favorite on classic rock stations. Its intended message is that love transcends the actual physical existence of the partners. The Reaper refers to the Grim Reaper, a traditional personification of death in European folklore.

A fear of funeral planning equates to fear of death. Those who hold fear in one area of their lives often have fear in other areas. It won’t kill you to move away from the fear of funerals.

Act with love, plan ahead, and talk about what you might want. Your courage will help your family reduce stress at a time of grief, save money, and create a meaningful, memorable “good goodbye.”

On Create a Great Funeral Day, don’t fear the Reaper. Need more cowbell.

How Estate Planning Documents Help Prevent Elder Abuse

With age comes wisdom and often, vulnerability. While aging is inevitable, it’s often hard to face as previously routine tasks become more difficult or require the assistance of another. Suddenly, keeping up with the latest technology overwhelms an individual who abandons the project in frustration. Minds become addled and scam artists more creative making recognizing a scam more difficult. As a cruel backdrop to this increased vulnerability, once dutiful children seldom visit and outings with friends become sporadic. Loneliness ensues only exacerbating the helpless feelings that may accompany aging. These factors together with the continued global pandemic and our increased reliance on technology to connect create the perfect storm for exploitation of the elderly. Studies show that one in ten people over the age of 60 has experienced some form of abuse. Our aging population has never been more vulnerable, and we have a duty to protect them.

Unfortunately, abuse occurs and often isn’t discovered until months or years later, in some cases much too late to take corrective action. Telephone and mail scams jump to mind as examples of rampant elder abuse; however, sometimes the abuse comes from much closer sources. A family member, long-time friend, or even a trusted caregiver may take advantage in a needy situation. These individuals may rationalize their behavior because of their increased presence in the elder person’s life. If that individual provides access to certain necessities like rides to the doctor or helps with groceries, the situation becomes more complex and ripe for abuse. Pick up any newspaper, magazine, or browse the headlines online and you can find a story about the exploitation of the elderly. It has become an increasingly common, although preventable, occurrence.

Obviously, it’s hard to attribute the issue to just one cause. Usually, several factors lead to an abusive situation. As the following example illustrates, it’s a slippery slope. Assume that Denise took over check-writing duties to ease the emotional burden on her newly widowed mother, Molly. Molly expresses her immense gratitude for Denise’s help and tells her that she’d like to thank her and offers to pay tuition for her grandson, Graham. If Denise refuses the offer, it’s clear that she has done nothing wrong. Here Denise had the opportunity to use funds for her own benefit but refused. Perhaps Denise’s sense of duty prevented her from stroking the check, perhaps she knew that she lacked the legal authority, or perhaps she simply wanted to avoid a fight with her brother after her mother’s death.

Assume that several months pass and Denise moves Molly into Denise’s home because Molly started wandering the neighborhood. Although there are times that Molly sounds like herself, at others she’s elsewhere. The next time Molly mentions Graham’s tuition, Denise writes the check immediately. Here, it’s a little less clear whether Molly really intended for Denise to use the funds and whether Denise had the authority to write the check. That depends upon whether Denise was listed as a co-owner on the account or was acting pursuant to authority granted under a property power of attorney or as successor trustee under a trust. Even if Denise were acting under a property power of attorney or trust agreement, in most states, Denise has a duty to act in the best interests of Molly. In paying Graham’s tuition, Molly likely breached that duty.

Now let’s assume that Denise has been experiencing financial trouble and decides to write the check without any direction from Molly or completes the payee on a pre-signed check. Even though Molly had previously expressed her gratitude to Denise, Denise likely lacked proper legal authority to make that expenditure and could find herself facing charges of elder abuse. If Denise made an equal distribution to her brother, Sonny, or if Denise quit her job to provide full-time care to Molly, she still likely exceeded the scope of her authority in making distributions from Molly’s account. The foregoing example demonstrates the difficulty in drawing a bright line regarding the behavior, how easily even a well-meaning individual could misstep, and the importance of protecting the elderly against this type of exploitation.

The simplest, most effective way to prevent elder abuse begins with a well-drafted estate plan. The plan should include specific powers exercisable by the fiduciary, as the attorney-in-fact, or as successor trustee. A well-drafted estate plan that specifically prohibits or provides express powers gives instructions to the fiduciary, financial institutions, and third parties about the principal’s expectations, even when the principal loses the ability to express those preferences. These clear directions mean that more people know what should happen thereby decreasing the potential for abuse.

Most states have enacted laws with significant punishments designed to prevent elder abuse. Many also have agencies designed to receive reports of abuse and intervene, if warranted. If a family member has concerns about whether dad’s new friend has nefarious intent, consult an attorney to discuss options and make sure to keep communication open and non-judgmental. Some of these scams bring feelings of shame which makes it difficult for the victim to admit what happened. An experienced estate planning or elder law attorney can help discern signs of abuse and suggest controls, checks, and balances to protect against it.

It’s important for us to look out for one another. As we continue to navigate the ongoing pandemic, we need to encourage interactions and connections with family and friends. Periodically review estate planning documents to ensure that the fiduciary appointments serve the best interests of the principal. If one of the fiduciaries has experienced a change in circumstances, consider whether naming a co-fiduciary or another fiduciary altogether provides comfort. These safeguards will help protect our most vulnerable – the elderly.