The Revamping of the Kiddie Tax
Two weeks ago, I wrote about the benefits of hiring your children to work for your business. In keeping with the kiddo theme, today I want to tackle issues regarding the so-called "kiddie tax". My reason for doing so is that a major change was enacted to the tax rate structure of the kiddie tax in the Tax Cuts and Jobs Act (TCJA).
To provide some back story, many years ago Congress put the kiddie tax in place as a means to discourage family members in high tax brackets from shifting unearned (think investment) income to children and grandchildren who are in lower tax brackets. Essentially, if certain conditions were met, this income would be taxed at the parent's tax rate, if higher, even though the income legally belonged to the kid.
This was accomplished in a rather convoluted way by the child's filing of a special tax form that reported the parent's taxable income, filing status, etc. and figured the tax based on this information, but only on an amount of the unearned income exceeding certain levels, such levels determined by a formula depending on the situation. The parent could also elect to just report the income directly on his or her return, but most of the time that resulted in a higher tax amount. Also, if the parents of the child weren't married anymore (or were married but not filing a joint return), you had to use the parent with the higher income. AND, the income of siblings could also have an effect. Whew, I'm tired already just writing about it!
TCJA modified the tax rates and brackets so that now the tax situation of the parents or the income of any siblings is irrelevant. Instead, all net unearned income over a threshold amount of $2,200 for 2019 is taxed using the rates and brackets for of all things, estates and trusts.
Sounds much less complex, which is a good thing, right? Yes, it is quite a bit simpler than before, that is for sure. However, estate and trust tax brackets are notorious for how little income it takes to get quickly into the highest tax rates, so for many people affected by this, their tax bills will be significantly higher!
Here are the ordinary income tax brackets:
10% Bracket: $0 - $2,600
24% Bracket: $2,601 - $9,300
35% Bracket: $9,301 - $12,750
37% Bracket: $12,751 ñ higher
As you can see, it doesn't take much income before you are paying the very highest tax rate there is under the kiddie tax regime. The special capital gains and qualified dividend tax brackets are equally compressed. For example, the highest capital gain rate of 20% is paid on adjusted capital gains over only $12,950 in 2019.
The kiddie tax form, Form 8615, must be filed for 2019 if all the following conditions are met:
- The child has more than $2,200 of unearned income (up from $2,100 for 2018);
- The child is required to file a tax return;
- The child is either under age 18 at the end of the year, is age 18 at the end of the year but doesn't have earned income that was more than half of his or her support, or is a full-time student at least age 19 and under age 24 and doesn't have earned income that was more than half of his or her support;
- At least one of the child's parents is alive at the end of the year; and
- The child doesn't file a joint return for 2019.
These rules apply whether or not the child is a dependent of a parent.
Believe it or not, these rules are actually quite a bit less complicated than before the TCJA. Fortunately, the IRS provides some handy worksheets with Form 8615 that really help with the calculation.
Still, while the kiddie tax is somewhat easier to calculate under the TCJA, it can still be confusing. And, depending on your circumstances, your children or grandchildren may be hit even harder by the kiddie tax under these new rules.
Final note of caution: While a full discussion is beyond the scope of this article, it is important to note that an academic scholarship received by a student that are used to pay for expenses that are not "qualified tuition and related expenses" is taxable unearned income subject to the kiddie tax.