New Kiddie Tax Rules and Tips

The Small Business and Tax Opportunity Act was enacted on May 25, 2007, as part of the supplemental Iraq funding legislation. While it includes a number of worthwhile tax incentives for small businesses, it also includes some revenue raisers - including a broadening of the kiddie tax to reach children up to age 23. This change can affect a number of taxpayers and their children for tax years beginning after May 25, 2007 (generally your 2008 income tax return filed in 2009).

The kiddie tax curtails the ability of parents to significantly lower their family's tax bill by transferring investment assets to low-taxed minor children. Until 2008, a child under age 18 pays tax at his or her parent's highest marginal rate on the child's unearned (investment) income in excess of $1,700. Unearned income within reach of the kiddie tax includes interest, dividends and capital gains. (The kiddie tax does not apply to a child who is married and files a joint return for the tax year.)

THE NEW RULES

The new law did not change the kiddie tax rules for children under age 18. But it did expand the kiddie tax to apply (starting next year) where:

a child turns age 18, or turns age 19-23 if a full-time student, before the close of the tax year;
the child's earned income for the tax year doesn't exceed one-half of his or her support;
the child has more than $1,700 of unearned income (but the $1,700 may be higher after an inflation adjustment is released later this year for 2008);
the child has at least one living parent at the close of the tax year; and
the child doesn't file a joint return for the tax year.

This expansion of the kiddie tax rules attempts to curtail a strategy some wealthy (and some moderate-income) parents were advised to use to take advantage of a beneficial feature of the long-term capital gains rate.

This year (2008), the top tax rate on most long-term capital gains and corporate dividends is 15%. But to the extent these items would otherwise be taxed in the two lowest tax brackets—i.e., the 10% and 15% brackets—they are taxed at 0% for 2008 through 2010. Some families sought to benefit from these rates by gifting appreciated stock, mutual-fund shares, and other securities to their low-income, young-adult children who, if no longer subject to the kiddie tax rules and if in one of the two lowest tax brackets, could then sell them tax-free in 2008, 2009, and/or 2010. (Until 2006, the kiddie tax applied to children under the age of 14.) The new law will eliminate the opportunity to do this in many cases and can have a negative impact on families that did not engage in transfers of capital assets to children. However, if the earned income of a child over age 18, or age 19-23 if a full-time student, exceeds one-half his or her support, the kiddie tax rules won't apply and he or she will be able to take advantage of the 0% capital gains rates and his or her own bracket on other types of unearned income.

POSSIBLE COURSES OF ACTION

Earned income (e.g., from wages or self-employment) is always taxed at the child's tax rates. Thus, one way of providing a child with income without triggering increased tax liability under the kiddie tax rules is to employ the child (at reasonable compensation) in a trade or business owned by the parent.

Parents may want to reconsider any planned transfers of income-generating stocks, bonds, and other investments to children age 18, or those age 19-23 who are full-time students. However, placing or moving a child's funds into investments that produce little or no current taxable income can help avoid the kiddie tax. These investments include, for example, stocks and mutual funds oriented toward capital growth that produce little or no current income; vacant land expected to appreciate in value; stock in a closely-held family business that pays little or no cash dividends; tax-exempt municipal bonds and bond funds; and U.S. series EE savings bonds for which interest reporting may be deferred. Investments that produce no taxable income also include tax-advantaged savings vehicles, such as traditional and Roth IRAs (which can be established or contributed to if the child has earned income); qualified tuition programs (“529 plans”); and Coverdell education savings accounts (“CESAs”).

Disclaimer: In accordance with IRS Circular 230, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries, and Appraisers before the Internal Revenue Service, the information on this website is not intended or written to be used as, and cannot be used as or considered to be a "covered opinion" or other written tax advice, and should not be relied on for the purpose of (1) avoiding tax-related penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or tax-related matter(s) addressed herein, for IRS audit, tax dispute or other purposes.