What is a “Kiddie Tax”?

assoc 4:25 pm

What is a “Kiddie Tax”?  Is a question our accounting firm often hears.

Many parents seek to save income taxes by transferring assets from their names and placing those assets under their children’s names.  Property can be transferred to minor children using custodial accounts under the Uniform Gifts or Transfers to Minors Acts.  This income shifting tax strategy will allow some tax savings to occur but a special provision in the Internal Revenue Code known as the “kiddie tax” rules will limit the effectiveness of this tax plan.

Essentially, the kiddie tax rules apply to a child that has not reached age 18 before the close of the year or a child whose earned income does not exceed one-half of their support and the child is age 18 or is a full-time student between the ages of 19 to 23.   The kiddie tax rules come into play for a child who meets the above age requirements and has more than $2,100 for 2016 of unearned (investment) income.   The mechanics of the kiddie tax rules will force unearned income of $2,100 to be subject to tax at the parent’s income tax rate (usually higher than the child’s).   While some tax savings on up to $2,100 of unearned income can be afforded to children under the cutoff age, the tax savings can be limited.

A child’s earned income (as opposed to investment income) such as wages is taxed at the child’s tax rate, regardless of the amount earned.  Therefore, to save taxes one tax planning strategy would be to employ the child and pay a reasonable salary for services performed in a business that the parent’s own and operate.

The kiddie tax rules only apply in cases where the investments produce taxable income.  Therefore, parents could consider shifting assets that produce little or no taxable income such as vacant land, tax exempt municipal bonds or stock in a closely held business that are expected to appreciate in the future. Another idea might be to contribute to a Roth IRA when the child has earned income.

When the kiddie tax applies, it’s computed and reported on Form 8615, which is attached to the child’s tax return.   Under some circumstances, parents can elect to report the child’s income on their own tax return by using Form 8814.  However, it is important to consider this approach and the effect it has on the parent’s adjusted gross income which could affect various floors and ceilings for deductions and limitations on the parent’s tax return.

The kiddie tax rules can be complex and every situation can be a little bit different.  Please contact our office if you have any questions.   We would be happy to discuss this topic further with you.