The so-called “kiddie tax” is designed to prevent parents or other relatives from shifting investment income to a child in a lower tax bracket. Since its enactment as part of the Tax Reform Act of 1986, the kiddie tax rules traditionally tied the tax on a child’s unearned income to the tax rates of the child’s parents. However, a law change made by the 2017 Tax Cuts and Jobs Act uncoupled the kiddie tax from the parents’ rates. Instead, effective for tax years beginning after 2017 and before 2026, the law change provides that the tax on a child’s unearned income was to be figured using the tax brackets for estates and trusts (with some modifications).
Since the tax rates for estates and trusts increase more steeply than the individual income tax rates, this change could result in an increase on the kiddie tax for some families.
Kiddie tax reset overview
Effective for tax years beginning after 2019, the Setting Every Community Up for Retirement Enhancement Act repeals the law change made by the Tax Cuts and Jobs Act.
As under prior law, the kiddie tax applies to a child’s net unearned income if the child is under age 19 or is a full-time student under age 24, has at least one living parent, has unearned income above a threshold amount ($2,200 for 2020), and doesn’t file a joint return with a spouse for the year. In the case of a child over age 17, the kiddie tax applies only if the child’s earned income does not exceed one-half of their support.
Under the kiddie tax, a child is taxed at normal tax rates on earned income plus unearned income up to the threshold amount. Thus, for 2020, the normal tax rates apply to a child’s earned income plus $2,200 of unearned income. A child’s net unearned income (above the amount taxed at the child’s rate) is taxed to the child at his or her parents’ tax rate (assuming that rate is higher than the child’s rate).
Specifically, the child’s tax on net unearned income is the amount of the child’s share of the “allocable parental tax.” For this purpose, the allocable parental tax is the excess of the tax that would be imposed on the parents’ taxable income if that income included the net unearned income of all the parents’ children subject to the kiddie tax, over the tax that would be imposed on the parents’ taxable income without regard to the kiddie tax. The child’s share is the amount of tax that bears the same ratio to the total allocable parental tax as the child’s net unearned income bears to the total unearned income of all of the parents’ children subject to the kiddie tax.
Under rules that were untouched by the Tax Cuts and Jobs Act, a parent can sidestep the kiddie tax by reporting a child’s income directly on the parent’s return. This election can be made if:
- The child’s income is only from interest and dividends (including capital gains distributions).
- The child’s gross income for the year is more than the minimum standard deduction for dependents ($1,100 for 2020).
- The child’s gross income is less than 10 times the minimum standard deduction ($11,000 for 2020).
- No estimated tax payments were made for the child and the child’s income was not subject to backup withholding.
If a parent makes the election, by filing Form 8814, Parent’s Election to Report Child’s Interest and Dividends, the child is treated as having no gross income for the year and is not required to file a return. The child’s gross income in excess of twice the standard deduction amount ($2,200 for 2020) is included in the parent’s gross income. The parent’s tax is calculated on the parent’s taxable income including the additional income of the child. However, the parent must also pay an additional tax equal to 10 percent of the lesser of the dependent standard deduction amount ($110 for 2020) or the excess of the child’s income over the standard deduction amount.
Optional reset for 2018 and 2019
Repeal of the Tax Cuts and Jobs Act change technically applies for 2020 and later tax years. However, a special rule allows taxpayers to retroactively elect to apply the reset kiddie tax rules for 2018 and 2019. The law specifically provides that a taxpayer may make the election “at such time and in such manner as the Secretary of the Treasury (or the Secretary’s designee) may provide ….” However, at the time of writing this article, the IRS has not yet spelled out rules for making the election.
KEY POINT: Given the potentially higher kiddie tax under the estate and trust rates, some of your clients may have opted to simply include kiddie tax income on their own returns. It is unclear whether the optional reset for 2018 and 2019 will allow those clients to retroactively apply the restored kiddie tax rules — or whether the reset is limited to those clients who separately calculated the kiddie tax.