Surprising Expansion of "Kiddie Tax"

There has recently been a surprising expansion of the “kiddie tax,” enacted by Congress in the Small Business Act of 2007. If you have children under age 24 as of 2008, this is of importance to you.

Background

For many years, the tax law has imposed the kiddie tax on the unearned income of a younger child. The concept of the kiddie tax is to apply the parents’ top tax rate to the investment income, such as interest, dividends and capital gains, of a child. For many years, the kiddie tax only applied to the unearned income of a child under age 14. But in 2006, Congress extended this tax to reach those under age 18 at year end. The motivation, of course, is to prevent parents from shifting investment income into the lower bracket tax returns of their children.

The kiddie tax has a very small exemption. Under current rules, investment income of a child under age 18 avoids Mom and Dad’s top tax rate only if that income is under $1,700. Also, a child is exempt if married and filing a joint return.

New Legislation

In the recent tax bill, effective with the 2008 tax year, the kiddie tax has been expanded in a very complex manner to potentially apply to children under age 24 as of year end. This extended version of the kiddie tax targets two groups who have attained age 18: 1) those who reach their 18^th birthday during the year, and 2) those in full-time student status for at least five months of the year who attain their 19^th through 23^rd birthday during the tax year.

But there is a further test for those in these age 18-23 groups. The kiddie tax only applies if the earned income of the child (wages and self-employment income) does not exceed one-half of the child’s support for the tax year. In calculating support, amounts covered by scholarships are not taken into account.

The amount of support for a particular child for a specific tax year can be difficult to quantify. Support takes into account all expenditures for an individual’s food, shelter, clothing, medical care, education, recreation and the like. Often, support is provided in-kind, such as lodging provided by parents. In that case, the item is measured in terms of its fair market value. If a child age 18 or a student age 19-23 has low wage income, they will likely now be subject to the kiddie tax starting in 2008, because their earned income will be under half of their support for the year.

The good news is there are some planning strategies to potentially mitigate the “kiddie tax”. Also, to avoid the hassle and cost of filing an amended return, if you have a child age 19-23 who is a full-time student with unearned income over $1700, they should verify whether they would be subject to the “kiddie tax” before they file their 2008 tax returns. If you may have a child subject to “kiddie tax” in 2008, you should consult your accountant here at Terry, Lockridge & Dunn to discuss possible planning strategies.

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