Giving a significant amount of investment assets to one’s children used to be a popular tax strategy, since it permitted the income earned on the investment to be taxed at the child’s presumably lower tax rate. Congress, in its kind-hearted way enacted the so-called “kiddie tax” in 1986 to prevent parents from abusing this strategy. In 2006 the rules became even more restrictive. With President Trump’s tax reform (the so-called “Tax Cuts and Jobs Act” or TCJA) signed into law on December 22, the “kiddie tax” now has a really fierce bite, all in the name of tax simplification, of course! Successful investments will now carry a heavy tax cost for young people. Learn all about the new rules so your future planning can be improved and made more tax efficient.
Let’s understand some basic concepts, first. An individual can have what is called “earned income” and “unearned income”. In the case of a child, think of “earned income” as compensation he receives, for example, for part-time work or a summer job. As for “unearned income” think of the follow examples — dividends paid on stocks gifted to him by his grandparents, or the capital gain upon selling the shares; interest income earned on a bond or from cash gifts put into his bank account. Under the “kiddie tax” provisions prior to TCJA, the net unearned income of the child was often taxed at the parents’ tax rates if the parents’ tax rates were higher than the tax rates of the child.
Kiddie Tax
The kiddie tax applies to a young person if: (1) the child had not reached the age of 19 by the close of the tax year, or the child was a full-time student under the age of 24, and either of the child’s parents was alive at such time; (2) the child’s unearned income exceeded $2,100 (this is a limit that is set annually based on inflation and for 2018, the limit is set at $2,100; for 2019 it is set at $2,200); and (3) the child did not file a joint return.
The New Law
For tax years beginning after December 31, 2017 (i.e., starting in 2018, the tax return you are currently working on), the taxable income of a child attributable to earned income is taxed under the rates for single individuals (see chart below), and taxable income of a child attributable to net unearned income is taxed according to the brackets applicable to trusts and estates. As can be seen from the chart below, applying the tax brackets for trusts and estates to a child’s investment income means that the 37% highest tax rate will apply to a child’s unearned income once it exceeds $12,500. By comparison, the 37% highest tax rate does not apply to single individuals until all taxable income (not just investment income) exceeds $500,000; and for married couples filing a joint return, the 37% rate does not kick in until all taxable income (not just investment income) exceeds $600,000.
This harsh new kiddie tax rule applies not only to the child’s unearned income that is taxed at ordinary income rates (such as interest income), but it also applies to the child’s income that would otherwise be taxed at preferential rates (e.g., qualified dividends and long-term capital gains that would otherwise be eligible for tax at favorable lower rates of 15% or 20% depending on income thresholds).
I have given only a very simplified explanation of the new TCJA rules. Despite Congress’s intent to simplify the kiddie tax, the TCJA introduced new elements that make its computation far more complex, including introduction of the new concept of “earned taxable income”.
IRC Code Sec. 1(j)(4), as amended by Act Sec. 11001(a))
2018 TAX RATES
FOR ESTATES AND TRUSTS:
| Taxable Income | Tax payable |
|---|---|
| Not over $2,550 | 10% of taxable income |
| $2,551 – $9,150 | $255 + 24% of the excess over $2,550 |
| $9,151 – $12,500 | $1,839 + 35% of the excess over $9,150 |
| $12,501+ | $3,011.50 + 37% of the excess over $12,500 |
FOR SINGLE INDIVIDUALS (OTHER THAN HEADS OF HOUSEHOLDS AND SURVIVING SPOUSES):
| Taxable Income | Tax payable |
|---|---|
| Not over $9,525 | 10% of taxable income |
| Over $9,525 but not over $38,700 | $952.50 plus 12% of the excess over $9,525 |
| Over $38,700 but not over $82,500 | $4,453.50 plus 22% of the excess over $38,700 |
| Over $82,500 but not over $157,500 | $14,089.50 plus 24% of the excess over $82,500 |
| Over $157,500 but not over $200,000 | $32,089.50 plus 32% of the excess over $157,000 |
| Over $200,000 but not over $500,000 | $45,689.50 plus 35% of the excess over $200,000 |
| Over $500,000 $150,689.50 | plus 37% of the excess over $500,000 |
FOR MARRIED INDIVIDUALS FILING JOINT RETURNS AND SURVIVING SPOUSES:
| Taxable Income | Tax payable |
|---|---|
| Not over $19,050 | 10% of taxable income |
| Over $19,050 but not over $77,400 | $1,905 plus 12% of the excess over $19,050 |
| Over $77,400 but not over $165,000 | $8,907 plus 22% of the excess over $77,400 |
| Over $165,000 but not over $315,000 | $28,179 plus 24% of the excess over $165,000 |
| Over $315,000 but not over $400,000 | $64,179 plus 32% of the excess over $315,000 |
| Over $400,000 but not over $600,000 | $91,379 plus 35% of the excess over $400,000 |
| Over $600,000 | $161,379 plus 37% of the excess over $600,000 |
What To Do
Parents (grandparents and other relatives) must immediately consider the effects of the new law. While many may want their children with dual nationality to immediately give up US citizenship, minors cannot relinquish their citizenship and parents cannot do it for them. Renunciation of one’s citizenship is regarded as a personal elective right that cannot be exercised by another person. Please contact me if you wish further information about minors and relinquishing US citizenship.
In light of the revised kiddie tax rules, it’s time to re-think gift-giving of investment assets to young children. Now more than ever, picking the wrong savings vehicle for your children’s future educational or life needs can cost thousands in avoidable taxes. A follow-up blog post will separately examine how Americans living and working abroad might plan for tax-efficient educational savings for their children.
Does the Child Have Foreign Financial Accounts or other Foreign Financial Assets? File that FBAR and Form 8938
Don’t forget, even children must file the so-called FBAR if it is required! This is made clear in the FBAR filing instructions. If you don’t know about FBAR, please see my US Tax Primer and read some fast FBAR facts.
Responsibility for Child’s FBAR
Generally, a child is responsible for filing his or her own FBAR report. If a child cannot file his or her own FBAR for any reason, such as age, the child’s parent, guardian, or other legally responsible person must file it for the child.
Signing the child’s FBAR
If the child cannot sign his or her FBAR, a parent or guardian must electronically sign the child’s FBAR. In item 45 Filer Title enter “Parent/Guardian filing for child”
If certain monetary thresholds are met and the child is required to file a tax return, the child may also be required to file Form 8938 – Statement of Specified Foreign Financial Assets. This Form is completely separate and distinct from the FBAR. It is not replaced by the FBAR. You can learn more about Form 8938 at my blog postings here and here.
See IRS Form 8615, Tax for Certain Children Who Have Unearned Income, and IRS Publication 929, Tax Rules for Children and Dependents, to assist in figuring out the complexities of the kiddie tax for the 2018 tax year.
Published February 11, 2019
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