The Tax Cut and Jobs Act (TCJA), passed by Congress in 2017, introduced numerous changes to the tax code. While some changes may negatively affect a tax practitioner’s clients, other changes will have a more positive outcome.
One positive change is the Kiddie Tax, which potentially affects a taxpayer with one or more dependent children who received unearned income during tax year 2018. Overall, the changes to the Kiddie Tax rules are relatively small, and the TCJA streamlined the rules a bit; however, it is still important to look at the overall impact these changes can create on a taxpayer’s final tax bill.
The biggest change is found in IRC Secs. 1(j)(4)(B) and (C). In these sections, the child’s maximum taxable income shall not be taxed at a rate lower than the 24 percent, 35 percent or the 37 percent rate that is more than the sum of the child’s earned taxable income, plus the minimum taxable income for the applicable tax brackets listed in IRC Sec.1(j)(2)(E).
Earned taxable income (ETI) is defined in Sec. 1(j)(4)(D) as a child’s taxable income reduced by net unearned income. ETI adjusts the upper limit for each bracket of the rate table for estates and trusts to determine the amount of tax owed. Note that ETI is a new term, calculated separately from a child’s earned income.
Paragraph (2)(E) of Sec. 1(j) modifies the rates for estates and trusts, and replaces the parent’s marginal tax rate applied to the net unearned income of a dependent child beginning in tax years after Dec. 31, 2017, and ending before Jan. 1, 2026.
|Ordinary Income Tax Rates for Trusts and Estates for Tax Years 2018 to 2025|
|$0 – $2,550||10% bracket|
|$2,551 – $9,150||24% bracket|
|$9,151 – $12,500||35% bracket|
|$12,501 and more||37% bracket|
Any long-term capital gains and/or qualified dividends a taxpayer’s child receives uses the capital gains rate for estates and trusts.
|Long-Term Capital Gains and Qualified Dividend Tax Rates for Trusts and Estates for Tax Years 2018 to 2025|
|$0 – $2,600||0% bracket|
|$2,601 – $12,700||15% bracket|
|$12,701 and more||20% bracket|
Keep in mind two things regarding these new tax rates:
- The highest rate for ordinary income is 37 percent and 20 percent for capital gains. Under the prior IRC, ordinary income could be taxed at a rate as high as 39.6 percent, or 20 percent for capital gains and qualified dividends.
- Comparing the trust and estate rates to the parent’s schedules shows more compressed income rate brackets than the individual tax tables.
Preparers should make their clients aware of this change to avoid surprises, as well as take any possible steps to avoid an unfavorable tax rate. The TCJA changed the tax rates of the Kiddie Tax, but the remaining rules remain. This includes how net unearned income is calculated, along with the age and support tests prescribed under IRC Sec. 1(g)(2)(A). A taxpayer’s child is still subject to the Kiddie Tax until the age of 24 if all of the following apply:
- The child didn’t file a joint return.
- One or both parents are alive at year end.
- The child’s net unearned income is greater than the unearned income threshold ($2,100 for 2018) and has positive income after any applicable deductions, including the dependent’s standard deduction.
- The child meets one of the age-related conditions for being a dependent.
To illustrate the impact of the TCJA, consider the following situation:
Mark is a client who files a joint return. He has two children, Karen, age 13, and Jack, age 19. Jack is a full-time university student. Both Karen and Jack are dependents on Mark’s tax return. Jack earns $2,300 in wages at a part-time job and received $8,000 in interest from bonds gifted by his grandfather. Jack also sold some stock gifted to him when he was age 10 for a capital gain of $1,200. Karen had no income.
Jack’s gross income is $11,500, with $2,300 earned income and $9,200 unearned income. His standard deduction is $2,650 ($2,300 earned income + $350), giving Jack a taxable income of $8,850.
Jack’s unearned income of $9,200 is reduced by the $2,100 unearned income threshold for a net unearned income of $7,100. Earned taxable income for Jack is the difference between his taxable income and net unearned income. In this case, Jack’s ETI is $1,750. ETI is added to each bracket of the estates and trusts rate tables.
The $1,200 of capital gains is taxed at the 15 percent bracket on the long-term capital gains table for Estates & Trusts (Jack’s taxable income of $8,850 pushes him into the 15 percent tax bracket). The remaining taxable income will be taxed from the ordinary income tax rates for Estates & Trusts.
Jack’s remaining taxable income after the capital gains is $7,650. The first $4,300 ($2,550 + ETI of $1,750) is taxed 10 percent, and the remaining $3,350 will be taxed at 24 percent.
As a result, Mark owes $1,414 ($180 for the $1,200 of long-term capital gains plus $430 at the 10-percent rate and $384 at 24 percent) in total tax on Jack’s behalf.
In prior tax years, if Mark had had a marginal tax rate of 35 percent, Jack’s tax on his net unearned income would have been $2,779.
As seen from the example above, the amounts owed can be significantly different from 2017. While this is a favorable change, a tax practitioner should pay particular attention to any clients whose children have appreciable assets that have recently grown in value. It may be helpful to discuss selling down the assets sooner, rather than later, to manage any gains and help reduce the Kiddie Tax. Regardless of the situation, it will be critical for a tax practitioner to reach out to any clients with dependent children and ensure they are properly prepared for all changes the TCJA will bring in the coming tax season.
Editor’s note: This article has been updated with clarifying edits to the example.