New Complex Kiddie Tax Rules

For many years, Congress has imposed the infamous “kiddie tax” on the unearned income of a younger child. The motivation has been to prevent parents from shifting investment income, such as interest, dividends and capital gains, to the lower bracket tax returns of their children. From its inception, the kiddie tax applied the parents’ tax rate to the unearned income of a child under age 14. But beginning in 2006, Congress extended the kiddie tax to reach those under age 18.

The kiddie tax allows the child to have only $1,700 of investment income and gains at the child’s low rate. Any excess is taxed at mom and dad’s top tax rate.

Now, in the recent tax legislation, effective beginning with the 2008 tax year, the kiddie tax has been expanded in a very complicated manner to potentially reach children through age 23! This expanded kiddie tax actually aims at two groups who have attained age 18: (1) those who have their 18th birthday during the year, and (2) those who are in full-time student status for at least five months of the year and attain their 19th through 23rd birthday during the particular tax year.

But there is a further test for those in this age 18-23 upper tier group. For the kiddie tax to apply, the individual must have earned income, such as from wages and self-employment income, that does not exceed one-half of the amount of the individual’s support for the tax year. In measuring support, amounts received as a scholarship are not taken into account.

Support, of course, is a figure that is difficult to quantify. Support takes into account the various expenditures for that child during the year, such as food, shelter, clothing, medical care, education, recreation and the like. Often, support is provided in kind, such as lodging provided by parents. In that case, the item is measured in terms of its fair market value. In determining support, only amounts actually expended or provided during the particular year are considered. If the child has low personal earnings (wages and self-employment income) compared to the support amount, he or she will be subject to the kiddie tax during the years 18-23, assuming he or she is also in student status. But if the child has a larger wage amount compared to his or her support, the child will be exempt.

Example. Ben is a college student, age 20, with several scholarships. During 2008, items expended for Ben’s support include room, board, tuition and other items that total $26,000. However, Ben has received several scholarships in the total amount of $6,000 that reduce the outlay for his tuition. Accordingly, his total support for 2008 is $20,000. Ben has a W-2 from employment at his school during 2008 for $7,000. Ben is subject to the kiddie tax, because his earned income of $7,000 does not exceed $10,000 (half of his support for the year excluding the amount covered by scholarships).

If Ben had greater wages for 2008, such as $11,000 in total employment, he would not be subject to kiddie tax. In that case, Ben could recognize interest and dividend income or sell securities with significant capital gain recognition without imposition of his parents’ tax rate on his unearned income.

Observation: A surprising aspect of this kiddie tax expansion is that its application has no bearing on the child’s dependency deduction. The dependency exemption for a student or young adult generally goes to the party (parent or child) that provided over half of that child’s support for the year. The kiddie tax, instead, simply looks to the W-2 and self-employment income of the student, and does not consider who provided the sources of support for the child for the year.

In many cases, particularly among upper income families, a student may not be a dependent of the parents because the student’s assets (received through earlier gifts from parents or grandparents) have provided over half of the student’s support for the year. And yet that student could be subject to kiddie tax at the parents’ tax rate, simply because the student had low W-2 income for the year. It is even possible under this set of rules to have the kiddie tax apply to an estranged child who no longer is in communication with the parents!

Strategies.  Here are some thoughts about how to react to this new kiddie tax. First, because the age 18-23 rule does not take hold until 2008, those who have children presently in that age group should consider recognizing gains and investment income in their tax returns during 2007. A 19-year- old’s mutual funds and stocks can be sold in this year without any kiddie tax, but it may be a different story next year.

Secondly, is it possible the child’s W-2 and self-employment earnings could approach over half of their support amount, so that the 2008 kiddie tax did not apply? If so, adding to that W-2 income by employing the child in a family business could be of benefit.

Investment strategies for saving for college for a child will need rethinking. Rather than build up funds that will now be cashed in kiddie tax years when needed for college, consider the efficiency of state-sponsored 529 plans. These investments are never taxed if withdrawn and expended for higher education.  

Finally, for many, the kiddie tax may not be that costly, at least with respect to capital gains. For example, if a child is holding unsold stocks that have been received as a gift from parents, the sale will produce a capital gain. At the child’s rate, it would be taxed at 0% in 2008, but with kiddie tax it is a 15% capital gain rate. While no tax is the perfect answer, the full capital gain rate of 15% is hardly a confiscatory tax.

If any of these strategies merit discussion with respect to your personal situation, let us know.

For more information on this or other tax issues, contact Jeff Winkleman, CPA at jwinkleman@marg.com.