The Kiddie Tax Goes to College
Kent N. Schneider1
Given the progressive nature of the federal income tax rates, shifting income from a high-bracket taxpayer to a family member with a lower marginal tax rate can reduce a family’s income tax burden. Although income generated from one’s labor cannot be transferred to another taxpayer’s return,
2 the income produced by investment property can be shifted to another taxpayer by transferring ownership of the investment property.
3 Since parents typically have a higher marginal tax rate than their children, parental gifts of investments to children have the potential to produce tax savings. This potential will be more pronounced for tax years 2008 through 2010, when the tax rate on qualified dividends and long-term capital gains drops to 0% for taxpayers in the 10% and 15% brackets.
4
To limit use of this strategy, Congress enacted the “Kiddie Tax” as part of the Tax Reform Act of 19865 and subsequently expanded its scope in 20066 and, again, in the Small Business and Work Opportunity Tax Act of 2007 (SBWOTA).7 This article will review the operation of the Kiddie Tax, examine the effects of this recent legislation on the Kiddie Tax, and explore strategies for avoiding or minimizing the effect of the Kiddie Tax on the three distinct classes of taxpayers now subject to this provision.
I. The Kiddie Tax as a Constraint on Income Shifting
The Kiddie Tax reduces the incentive for shifting investment income to a child by limiting the amount of unearned income that can be taxed at the child’s low marginal tax rate. The parent’s tax rate is applied only to the child’s “net unearned income,” typically the child’s investment income in excess of a statutory threshold equal to twice the minimum standard deduction amount for dependents.8 In 2007, the minimum standard deduction for dependents is $850.9 Thus, a child’s net unearned income this year would be the child’s investment income minus $1,700. If a child’s investment income was $1,700 or less, the Kiddie Tax would not apply.
Example 1: Eric, age 12, receives $2,000 interest from a savings account in 2007. This is his only income for the year, and he is claimed as a dependent on his parents’ return.
Eric’s net unearned income is $300, as shown below.
Unearned income:
$2,000
Less: Kiddie tax threshold (1,700)
Net unearned income: $ 300
Consequently, $300 of his taxable income will be taxed at his parents’ marginal tax rate.
When first enacted, the Kiddie Tax was imposed on children with net unearned income only if they were under age 14 and had a living parent as of the last day of the tax year. Once a child reached age 14, the Kiddie Tax ceased to be a constraint on intra-family income shifting.10 This rule remained undisturbed for nearly two decades.
II. Expanding the Kiddie Tax
A. Revenue Raiser
In 2006, as part of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), Congress expanded the Kiddie Tax’s reach to children under age 18. Included among the “revenue offset provisions” of TIPRA, Congress clearly intended this change to be one of many revenue raisers included in the act. This change was effective for tax years beginning after 2005. However, since TIPRA was not signed by the president until May 18, 2006, this change had a retroactive effect, giving tax planners little opportunity to react.
B. Loophole Closer
More recently, Congress again expanded the Kiddie Tax, casting its net to include two new groups. For tax years beginning after the date of enactment (May 25, 2007) of SBWOTA, the Kiddie Tax will apply to a child who is age 18, but only if the child’s earned income is less than half of the child’s total support.11 Similarly, a child over age 18, but under age 24, will be subject to the Kiddie Tax if the child’s earned income is less than half of his total support and if the child qualifies as a student.12
As with TIPRA, the purpose of the 2007 act was to restrict income shifting. However, this time the stakes were higher. Before 2008, the reward for intra-family income shifting was a maximum reduction from the parents’ top marginal tax rate of 35% to the child’s 10% rate for ordinary income and from the parents’ 15% tax rate for long-term capital gains and qualified dividends to the child’s rate of 5%. These rate differentials are significant and no doubt fueled the TIPRA change. However, beginning in 2008, the tax rate for long-term capital gains and qualified dividends of taxpayers in the 10% and 15% brackets drops from 5% to 0%.13 Thus, appreciated investment property given to children who are not subject to the Kiddie Tax, and who are in the 10% or 15% tax brackets, can be sold tax-free in 2008 through 2010.
Example 2: Eric, age 14, receives a gift of stock from his parents in 2008. His parents paid $1,000 for the stock several years ago, but Eric immediately sells the stock for $20,000 and invests the proceeds in a mutual fund. This gain on this sale is his only income for the year, and he is claimed as a dependent on his parents’ return.
Eric will be subject to the Kiddie Tax in 2008, since he is under 18 years of age. Assuming Eric’s parents have a marginal tax rate of 25% or higher, he will be taxed on the portion of the long-term capital gain included in his taxable income at his parents’ 15% rate, rather than his 5% rate.
Example 3: Same facts as in Example 2, except that Eric is 24 years of age.
Eric is not subject to the Kiddie Tax in 2008, since he is 24 years or older. Thus, his long-term capital gain on the stock sale will be included in his taxable income, but it will be taxed at his own 0% rate!
III. Kiddie Tax Requirements
The recent legislation has created three distinct categories of children who are subject to the Kiddie Tax. However, all three groups have common requirements. First, a child must have a living parent on the last day of the taxable year.14 Second, the “child does not file a joint return for the taxable year” in question.15 Finally, the child must have net unearned income.16 If any of these elements are missing, the Kiddie Tax is not applicable.
Assuming the common requirements are satisfied, the next step is to classify children based on the child’s age on the last day of the taxable year.17 A child under age 18 is subject to the Kiddie Tax18 without satisfying any other conditions. In contrast, 18-year-old children will be subject to the Kiddie Tax only if their earned income for the taxable year is less than half of their total support. Finally, children ages 19 through 23 are exposed to the Kiddie Tax only if earned income is less than half of total support and then only if they are students. For a summary of these requirements by age group, see Figure 1.
Figure 1
| Kiddie Tax Requirements |
Under 18 |
Age 18 |
Ages 19 to 23 |
| 1. Living Parent |
x |
x |
x |
| 2. Did not file joint return |
x |
x |
x |
| 3. Unearned income in excess of the Kiddie Tax threshold |
x |
x |
x |
| 4. Earned income < 50% of support |
|
x |
x |
| 5. Full-time student |
|
|
x |
A. Earned Income as a Percentage of Support
Beginning in 2008, when a child reaches age 18, he will not be subject to the Kiddie Tax unless his earned income is less than half of his total support.19 “Earned income” is income from labor, such as salary, wages, and professional fees.20 The definition of “support” is the same as found in the dependency requirements.21
Despite sharing the definition of “support,” this requirement is not identical to the dependency support tests for “qualifying child” and “qualifying relative” status. A “qualifying child” is one who does not provide more than half of his own support.22 Similarly, a “qualifying relative” is one who receives more than half of his support from the taxpayer claiming the dependency exemption.23 In either case, the amount of “earned income” of the dependent is not relevant to the determination of dependency status. Thus, it is possible for a child between the ages of 18 and 23 to be subject to the Kiddie Tax despite failing to qualify as a dependent.
Example 4: Trudy, age 18, provides all of her own support of $10,000 in 2007. She earns wages of $4,000 and receives interest income of $6,000.
Trudy will not qualify as a dependent of her parents since she provided more than half of her own support. On the other hand, Trudy will be subject to the Kiddie Tax because her earned income ($4,000 of wages) is less than half of her total support and her unearned income ($6,000 of interest) exceeds the 2007 Kiddie Tax threshold of $1,700.
The determination of both “support” and “earned income” is more complex when the child is the recipient of scholarships. Scholarships are disregarded as support if the recipient is the child of the taxpayer and a full-time student.24 This is true, not only for purposes of establishing dependency status, but also for determining Kiddie Tax exposure.25 As for earned income, however, there is a divergence in treatment. The taxable portion of scholarships — for example, the portion covering room and board — is classified as earned income for purposes of determining the dependent’s limited standard deduction under IRC § 63(c)(5).26 Unfortunately, this treatment does not extend to the “earned income” test for Kiddie Tax purposes.
Example 5: Trudy, a full-time student who is 18 years of age, incurs living expenses of $30,000 in 2007, provided from the following sources:
Wages 4,000
Interest income 6,000
Parents’ contributions 8,000
Scholarship 12,000
Since Trudy is a full-time student, the scholarship is not included in her support for determining either dependency status or Kiddie Tax exposure, making her total support for the year only $18,000. As a result, Trudy is not a dependent of her parents, since she has provided more than half of her total support.
As in Example 4, Trudy will be subject to the Kiddie Tax because her earned income of $4,000 is less than half of her total support and her unearned income ($6,000 of interest) exceeds the 2007 Kiddie Tax threshold of $1,700.
B. Full-Time Student
A child over age 18, but under age 24, also can have Kiddie Tax exposure. As with 18-year-olds, a child in this age group must have earned income that is less than half of his support. In addition, he must be a “student.”27 Identical to the age requirement for a “qualified child” to be a dependent,28 “student” status requires one to be enrolled full-time at a qualifying educational institution during five calendar months of the tax year.29
Example 6: Heidi, a full-time student who is 22 years of age, provides all of her own support of $10,000 in 2007. She earns wages of $4,000 and receives interest income of $6,000.
Heidi obviously will not qualify as a dependent of her parents since she provided more than half of her own support. Even so, Heidi will be subject to the Kiddie Tax because her earned income ($4,000 of wages) is less than half of her total support and her unearned income ($6,000 of interest) exceeds the 2007 Kiddie Tax threshold of $1,700.
Example 7: Same facts as in Example 6, except that Heidi earns wages of $6,000 and receives interest income of $4,000.
As in Example 5, Heidi will not be a dependent of her parents since she provided more than half of her total support for the year. But, she will not be subject to the Kiddie Tax. Even though she is a full-time student between the ages of 18 and 24, Heidi will not be subject to the Kiddie Tax because her earned income of $6,000 exceeds half of her total support of $10,000.
IV. Opportunities to Avoid or Reduce Kiddie Tax Exposure
The strategies for avoiding or reducing Kiddie Tax problems depend upon not only the age of the child, but also the marital status of the child, the taxable year when the income is shifted to the child, and the type of investment property transferred to the child.
A. Marital Status
As previously mentioned, a child will not be subject to the Kiddie Tax if he files a joint return with his or her spouse for that tax year. This is true regardless of the child’s age, earned income, or status as a student. Moreover, since the lower tax brackets for a joint return are twice as large as for a single taxpayer, the potential tax savings from shifting income to a married child are much greater.
B. 2007 Transfers
Since the most recent changes to the Kiddie Tax are effective for tax years starting after May 25, 2007, children who reach age 18 (or older) by the end of the current year will not be subject to the Kiddie Tax until 2008. As a result, the remainder of 2007 provides a brief window for last minute rate-shifting of unrealized gains on investment property. To accomplish this goal, parents can give appreciated investment assets to a child over age 17. If the child sells the investments before the end of 2007, the long-term capital gain will be taxed at the child’s lower 5% tax rate.
C. Transfers After 2007
When the new rules take effect, children ages 18 to 23 can avoid the Kiddie Tax by making sure that their earned income for the year is greater than or equal to their total support. This can be accomplished by increasing earned income and reducing their support for the year. Becoming gainfully employed will increase the child’s earned income for the year. At the same time, living a simpler lifestyle and deferring some discretionary consumption expenditures (e.g., waiting until next year to buy that new car or HDTV) can reduce total support. Admittedly, neither strategy will be appealing to the child. But, the dramatic tax savings potential may be sufficient to obtain the child’s cooperation.
Even if earned income is less than total support, children ages 19 to 23 will be able to escape the Kiddie Tax by avoiding student status for the year. For most college students, this is not a viable alternative. However, if the child is engaged in full-time volunteer work for the year, such as serving in the Peace Corps or church missionary activities, this period can be an ideal time for income-shifting.
D. Investments that Postpone Income Recognition
Finally, Kiddie Tax avoidance strategies available to children of all ages include the use of special tax-favored vehicles and classic investment techniques that postpone income recognition. If saving for college is the goal, qualified tuition plans (“529 plans”) would be the optimal vehicle, since the income earned by the 529 plan accumulates tax-free. If the child has earned income, the parents could reimburse the child for contributions to the child’s Roth IRA. When shifting investment income to a child outside of tax-favored accounts, parents can transfer investment property that focuses on capital growth, rather than the generation of current income. Then, the child can dispose of the asset during a tax year when he is no longer subject to the Kiddie Tax.
Footnotes
1 Kent N. Schneider is a professor of accountancy at East Tennessee State University. He is a member of The Missouri Bar and The Missouri Bar’s Taxation Law Committee. He received his J.D. from the University of Missouri-Columbia and is a certified public accountant.
2 Lucas v. Earl, 281 U.S. 111 (1930).
3 Helvering v. Horst, 311 U.S. 112 (1940).
4 I.R.C. § 1(h)(B).
5 Tax Reform Act of 1986, Pub. L. 99-514, § 1411, 100 Stat. 2085 (1986), which added IRC § 1(g).
6 Tax Increase Prevention and Reconciliation Act of 2005, Pub. L. 109-222, § 510, 120 Stat. 345, amending IRC § 1(g)(2)(A).
7 Small Business and Work Opportunity Act of 2007, Pub. L. 110-28, § 8201, 8241, 121 Stat. 200, amending IRC §§ 1(g) and 1(g)(2)(A).
8 I.R.C. § 1(g)(4)(A)(ii). Note that, according to I.R.C. § 1(g)(4)(A)(ii)(II), this threshold can be greater than twice the minimum standard deduction for dependents if the child has itemized deductions directly related to the production of the unearned income that exceed the minimum standard deduction. In such a case, “net unearned income” would be the child’s investment income in excess of the sum of the child’s itemized deductions directly related to the investment income plus the minimum standard deduction.
9 I.R.C. § 63(c)(5).
10 If the child is a dependent of the parent, other constraints to income shifting continue to exist even if the Kiddie Tax does not apply. Specifically, dependents are not entitled to a personal dependency exemption under I.R.C. § 151(d)(2). Also, the dependent is subject to a limited standard deduction under I.R.C. § 63(c)(5).
11 I.R.C. § 1(g)(2)(A)(i), as amended by § 8241 of the Small Business and Work Opportunity Tax Act of 2007, Pub. L. 110-28, 120 Stat. 200 (2007).
12 I.R.C. § 1(g)(2)(A)(ii), as amended by § 8241 of the Small Business and Work Opportunity Tax Act of 2007, Pub. L. 110-28, 120 Stat. 200 (2007).
13 I.R.C. § 1(h)(1)(B).
14 I.R.C. § 1(g)(2)(B).
15 I.R.C. § 1(g)(2)(C).
16 I.R.C. § 1(g)(4).
17 I.R.C. § 1(g)(2).
18 I.R.C. § 1(g)(2)(A)(i).
19 I.R.C. § 1(g)(2)(A)(ii)(II).
20 I.R.C. §§ 1(g)(2)(A)(ii)(II) and 911(d)(2)(A).
21 I.R.C. §§ 1(g)(2)(A)(ii)(II) and 152(c)(1)(D).
22 I.R.C. § 152(c)(1)(D). In addition, I.R.C. § 152(c)(1) requires a “qualifying child” to have the “same principal place of abode” for more than half of the taxable year and be either under age 19 or a full-time student under age 24.
23 I.R.C. § 152(d)(1)(C). In addition, I.R.C. § 152(d)(1) requires a “qualifying relative” not be a “qualifying child” of any taxpayer and not have gross income that is greater than or equal to the dependency exemption amount. As a practical matter, the gross income limit for a “qualifying relative” ($3,400 in 2007) is so low that very little investment income can be shifted to a child who fails to satisfy all of the “qualifying child” requirements (e.g., the child does not live in the same principal abode of the parents for more than half of the year) without losing the dependency exemption.
24 I.R.C. § 152(f)(2).
25 I.R.C. §§ 1(g)(2)(A)(ii)(II) and 152(f)(2).
26 Prop. Treas. Reg. §1.117-6(b). See also the Conference Committee Reports for the Tax Reform Act of 1986.
27 I.R.C. § 1(g)(2)(A)(ii)(II).
28 I.R.C. § 152(c)(3)(A)(ii)
29 I.R.C. § 152(f)(2).