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How do Kiddie Tax Rule Changes Affect Your Client’s Tax Planning Strategy?

The kiddie tax rules have been a bit fluid these past few years. The decades-old tax law changed when Congress passed the Tax Cuts and Jobs Act (TCJA) in 2017, and then again when they passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act in 2019. These changes can be difficult to track, but one major benefit arose from this flurry of legislative activity: freedom of choice. For tax years 2018 and 2019, Congress permits taxpayers to apply the version of the law that works best for them. With a bit of planning, you can help your clients make the optimal selection.

Kiddie Tax History

The Tax for Certain Children Who Have Unearned Income, colloquially known as the kiddie tax, is an additional tax on a child’s investment income. This tax is calculated and reported on the child’s annual tax return unless the parents elect to report that unearned income as their own.

The kiddie tax was established in 1986 to prevent parents from shifting unearned income like interest, dividends, and capital gains to their children. Because children are almost always in lower tax brackets than their parents, transferring this income to children’s returns lowered families’ overall tax liabilities. Form 8615, Tax for Certain Children Who Have Unearned Income separates a child’s unearned income from their earned income and taxes it separately at the parents’ marginal tax rate, effectively negating any attempts to shift income into lower tax brackets.

Children are required to file Form 8615 if all the following are true:

  • They are required to file an income tax return.
  • They report more than $2,200 of unearned income.
  • At least one of their parents was alive at the end of the tax year.
  • They do not file a joint return with a spouse.
  • They were –
    • Under age 18 at the end of the tax year;
    • Age 18 at the end of the tax year and didn’t have earned income that was more than half of their own support; or,
    • A full-time student age 19 through age 23 at the end of the tax year and didn’t have earned income that was more than half of their own support (not including scholarships).

The tax is assessed only against unearned income that exceeds $2,200. Unearned income is defined as all taxable income other than earned income. This means that all the following categories are considered in the kiddie tax calculation:

  • Interest
  • Ordinary dividends
  • Capital gains
  • Rents
  • Royalties
  • Annuity income
  • Taxable scholarships and grants not reported on Form W-2
  • Unemployment compensation
  • Alimony
  • Income (other than earned income) received as the beneficiary of a trust

If parents would prefer to report their child’s unearned income on their own return, they can do so by filing Form 8814, Parents’ Election to Report Child’s Interest and Dividends.

2017 Change: Tax Cuts and Jobs Act

The kiddie tax calculation changed when Congress passed the Tax Cuts and Jobs Act (TCJA) in December 2017. As written in the law, beginning in tax year 2018 and through tax year 2026, a child’s kiddie taxable income would be taxed using the progressive tax tables for estates and trusts rather than the marginal tax rate of the parents. Disregarding the parents’ tax rates streamlined the kiddie tax calculation, which was especially helpful for divorced or separated parents or families with more than one child subject to kiddie tax. Although the relative simplicity of the TCJA-era kiddie tax rules was appealing, many taxpayers were saddled with a larger tax bill as a result. Estate and trust income tax brackets are narrower than income tax brackets, making it easier for kiddie taxable income to reach the highest marginal tax rate of 37%.

2019 Ordinary Income Tax Rates

IND - Married Filing/ Trust & Estates TABLE

2019 Change: SECURE Act

About two years later, as part of the SECURE Act, Congress effectively repealed the TCJA changes to kiddie tax. Beginning in 2020 and indefinitely into the future, kiddie tax rules reverted to pre-TCJA laws. This meant that a child’s unearned income was once again taxed using their parents’ marginal tax rates rather than the tax tables of estates and trusts.

The SECURE Act’s changes were motivated by the negative consequences the TCJA imposed upon Gold Star families. Gold Star families are immediate family members – spouses, parents, children, and siblings – of service members who were killed or died while serving in the Armed Forces. Gold Star families are often recipients of two types of survivor benefits: one from the Department of Defense (DOD) and one from the Department of Veterans Affairs (VA). Unfortunately, because of a decades-old rule against “double dipping,” Gold Star family members are unable to accept both. In an attempt to collect both, many survivors transfer one of the benefits to their children.

This shifting of income is captured under the kiddie tax under pre-TCJA and TCJA-era laws. But the TCJA-era laws almost always resulted in a higher tax bill for Gold Star families. Because these survivor benefits are generous, kiddie taxable income quickly reaches the maximum estate and trust tax bracket, ensuring most of the benefits are taxed at 37%. When transitioning the laws back to pre-TCJA standards, these benefits were instead taxed at the parent’s marginal tax rate, which – for most taxpayers – produced a lower tax bill.

Looking Forward

In tax years 2018 and 2019, taxpayers can choose the calculation method that works best for them. They can calculate kiddie tax using the parents’ marginal tax rates or using the trust and estate tax brackets. The law even permits taxpayers to amend returns to take advantage of this opportunity. In 2020, the law reverts to pre-TCJA law and only the parents’ marginal tax rates can be used.

If your clients have children who are subject to kiddie tax, this is something you should explore further. There may be a tax saving opportunity for you to present. You will need to prepare proforma returns to compare the results. By doing this strategic planning, you can help steer your clients make the most optimal selection.

Also, keep in mind with continuing legislative changes that can be difficult to track, tax planning is more complicated than ever. Take out some of the complexity with Corvee Tax Planning, which can help you generate tax planning proposals across thousands of possible strategy combinations on a multi-entity, multi-year basis. 

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