Age Limitation of Kiddie Tax Is Increased
The provisions regarding the kiddie tax were originally enacted as part of the Tax Reform Act of 1986 and are set forth in IRC Section 1(g). The kiddie tax rules provide that if a child is under a prescribed age as of the last day of the taxable year, all the unearned income of the child in excess of an inflation adjusted amount ($1,700 for 2007) will be taxed at the parent's highest marginal tax bracket if that rate is higher than what the child would otherwise pay. The kiddie tax was enacted to limit the income tax savings of shifting income to minor children who presumably would be in lower income tax brackets than their parents. However, the kiddie tax has a broad reach and applies equally to a child whose unearned income is the result of having saved earned income as well as to a child whose unearned income is the result of gifts of income-producing property.
As originally enacted in 1986, the kiddie tax applied to children who were under age 14 on the last day of the taxable year. The Tax Increase Prevention and Reconciliation Act (“TIPRA”) 1 raised the age limitation of the kiddie tax for tax years beginning after 2005 to children under age 18. TIPRA also provided an exception from the kiddie tax if the child was married and filed a joint income tax return with his or her spouse.
The Small Business and Work Opportunity Tax Act of 2007 2 expands the kiddie tax to apply to two groups of children: first, children who as of the last day of the taxable year have attained the age of 18 but are under age 19, and second, children who have attained the age of 19 but are under age 24 and are full-time students. Nevertheless, these two groups of children are subject to the kiddie tax only if the child's earned income does not exceed one-half of the child's support. The kiddie tax will continue to apply to children under age 18 regardless of the amount of their earned income.
Earned income includes wages, salaries, professional fees, and other amounts received as compensation for personal services. In determining whether a child's earned income exceeds one-half of the child's support, any scholarships received by the child for study at an educational institution described in IRC Section 170(b)(1)(A)(ii) are not counted in determining the amount of the child's support.
Analysis and comments
The expansion of the kiddie tax applies to tax years beginning after May 25, 2007, and thus as a practical matter, the new rules will apply beginning in 2008. Accordingly, children who will attain the age of 18 in 2007 (or who are full-time students age 19 but younger than age 24 in 2007) will not be subject to the kiddie tax in 2007 but will be subject to the kiddie tax in 2008. With respect to these children, consideration should be given to recognizing long-term capital gain in 2007 because it will be taxed at the child's tax rate. The child may also benefit from the special 5% long-term capital gain rate that applies during 2007.
Section 1(h)(1)(B) of the Code provides that to the extent a taxpayer's net capital gain would otherwise be taxed in the two lowest tax brackets (i.e., the 10% and 15% brackets), such capital gain is taxed at 5% for 2007, and 0% for 2008 through 2010. With respect to children who in 2008 through 2010 will have attained the age of 18 but would be younger than 19 or will be full-time students age 19 but will be younger than age 24, they can still take advantage of the special capital gains tax rates if they are not subject to the kiddie tax. Such a child will not be subject to the kiddie tax on his or her unearned income if the child's earned income for the year is more than one-half of his or her support. Employing the child in the family business or elsewhere may be an option. The compensation paid to the child will generate a deduction for the business and may provide the child with sufficient earned income to avoid the kiddie tax.
The kiddie tax can be avoided by investing the child's funds in investments that currently produce little or no taxable income, are tax-exempt, or are tax-deferred. These investments include stocks, mutual funds, and real estate investments oriented toward capital growth that produce little or no 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 the reporting of interest may be deferred. The expansion of the kiddie tax may also make saving for college through Section 529 plans and Coverdell Education Savings Accounts more attractive than using UTMA/UGMA accounts and traditional trusts which may subject the child to the kiddie tax.
Even though the kiddie tax may prevent income tax savings that could otherwise occur as a result of shifting income-producing assets to younger generations, estate tax savings from such transfers remain advantageous not only as a result of removing the asset from the parent's estate but also by removing the income (and the future growth of that income) from the parent's estate.
1 Pub. L. No. 109-222 (5/17/06).
2 Pub. L. No. 110-28, Act section 8241 (5/25/07).