Taxation of Children’s Unearned Income

Internal Revenue Code (IRC) §1(g) contains special rules known as the “kiddie tax rules” used to determine the federal income tax on children’s net unearned income. Prior to tax year 2018, parents included their child’s net unearned income with their own income, which meant the child’s income was taxed at the highest marginal tax rate. But the Tax Cuts and Jobs Act of 2017 (TCJA) partially simplifies the kiddie tax calculation by allowing a child’s net unearned income to be calculated independently.

In general, the kiddie tax rules apply if:

1. The child is under age 18; or the child is age 18 and doesn’t provide more than half of his or her own support, or is a full-time student under the age of 24 and doesn’t provide more than half of his or her own support;
2. Either of the child’s parents is alive at year-end;
3. The child’s unearned income exceeds $2,100 (for 2018); and
4. The child doesn’t file a joint tax return.

CHANGES TO THE KIDDIE TAX

In accordance with the new IRC §1(j), the applicable tax rates for a child’s net unearned income is based on the trust and estate tax-rate brackets and modified by the addition of the child’s earned taxable income to each of those brackets. Specifically, IRC 1(j)(4)(D) states that “earned taxable income” now means “the taxable income of such child reduced (but not below zero) by the net unearned income.” Note this subtle difference in the wording. The concept of earned vs. unearned income isn’t new, but this wording means the IRC now also specifies that “earned taxable income” is different from “earned income.”

In most cases, the net unearned income will be equal to the adjusted gross income (AGI) minus the earned income, including the standard deduction ($1,050 for 2018). But that isn’t always the case when earned income is included in the child’s AGI. For 2018, the tax-rate brackets for children’s interest and short-term capital gains under the kiddie tax rules are:

• 10% for the portion of taxable income up to the sum of earned taxable income and $2,550;
• 24% for the portion of taxable income above the sum of earned taxable income and $2,550 (i.e., the 10% rate limit) but not over the sum of earned taxable income and $9,150;
• 35% for the portion of taxable income above the sum of earned taxable income and $9,150 (i.e., the 24% rate limit) but not over the sum of earned taxable income and $12,500; and
• 37% for the portion of taxable income above the sum of earned taxable income plus $12,500 (i.e., the 35% rate limit).

If a child has net unearned income that’s taxed at a preferential rate, such as qualifying dividends and long-term capital gains, then the applicable tax rates for the child under the kiddie tax are:

• 0% for the portion of taxable income up to the sum of earned taxable income and $2,600;
• 15% for the portion of taxable income above the sum of earned taxable income and $2,600 (i.e., the 0% rate limit) but not over the sum of earned taxable income and $12,700; and
• 20% for the portion of taxable income above the sum of earned taxable income and $12,700 (i.e., the 15% rate limit).

Depending on the type and amount of net unearned income, the child may have a higher or lower tax liability because of the TCJA. For example, if the child has less than $10,000 of income from interest or short-term capital gains income, then the tax owed is likely to be less using the trust and estate tax rates (under the new rules) than what would’ve been owed using the parent’s marginal tax rates. Likewise, if the child has qualifying dividends, then he or she doesn’t benefit from the more favorable capital gains tax rates that apply to the income levels of a single taxpayer. But it might be lower than if the income were from interest. Parents with children subject to the kiddie tax may want to reevaluate the child’s investment portfolio to minimize the taxes owed under the TCJA.

KIDDIE TAX CALCULATION

Separating the child’s tax calculation from the parents’ calculation achieves a certain degree of simplicity, but the calculation still has some challenges. First, the taxable income is determined. Second, the net unearned income is determined. Third, the earned taxable income is determined. Finally, the tax is determined.

For example, consider a child who earns $7,000 of taxable interest income, who has no earned income, and whose parents are in the top individual tax bracket. Under the previous rule, the unearned income would be reduced by the statutory deduction and the standard deduction for a dependent ($1,050 each), resulting in a total reduction of $2,100. Thus, $4,900 remains to be taxed at the parents’ rate of 39.6%, and the statutory amount of $1,050 is taxed at the child’s rate of 10%. Thus, the total tax due from the child is $2,046.

Under the new rules, the same child has:

1. $5,950 of taxable income ($7,000 taxable interest income minus the $1,050 standard deduction);
2. $4,900 of net unearned income ($7,000 taxable interest income minus the $1,050 standard deduction and $1,050 statutory deduction); and
3. $1,050 of earned taxable income ($5,950 of taxable income minus $4,900 of net unearned income).

The tax in this case is $924, which is 10% of $3,600 ($1,050 of earned taxable income plus $2,550 from the first trust and estate tax rate) plus 24% of $2,350 ($5,950 minus $3,600).

Suppose the child earns $7,000 of qualifying dividends rather than interest. Now the child’s tax liability is only $345: The $1,050 of earned taxable income and the $2,600 from the first trust and estate capital-gains tax rate for a total of $3,650 is taxed at 0%, and the remaining $2,300 ($5,950 minus $3,650) is taxed at 15%.

These examples illustrate how different the new tax calculations are for tax year 2018 with the use of the trust and estate tax rates and the modifications to those rate brackets by the newly defined earned taxable income. As you can see, the kiddie tax is significantly lower when the child’s unearned income of $7,000 is qualifying dividends instead of interest. Each child’s tax rate schedule is now a moving target to calculate, adding a new twist to the complexity of the kiddie tax and the tax code.

© 2018 A.P. Curatola