Strategies for Minimizing the Kiddie Tax

History of the “Kiddie Tax
The kiddie tax was first enacted in 1986, when the tax only applied to children under age 14. For 2006 and 2007, the tax was changed to apply to children who were under age 18. Under additional changes made in 2008, and still in effect for 2010, a full-time student might be subject to the kiddie tax through age 23.

What Is the Kiddie Tax?
The purpose of the kiddie tax is to prevent parents in high income tax brackets from shifting income to their lower-income tax bracket children. The kiddie tax is calculated and reported on IRS Rorm 8615. The unearned income of the child is taxed at the parent’s rate, if it is higher than the child’s tax rate. In cases where there is more than one child subject to the tax, the unearned income of other children in the family must also be considered in the calculation.

Who Must File Form 8615 for the Kiddie Tax?
A child must file form 8615 and be taxed on unearned income at their parent’s tax rate if all of the following conditions are met:

• They are required to file a return. (See below for conditions under which a child is required to file a return)

• Investment income exceeds a certain dollar amount. For 2010, this is $1,900.

• At least one parent is alive at the end of the year.

• The child does not file a joint return.

• They are either: 

   *Under age 18 at the end of the year OR
   *Age 18 at the end of year but their earned income was not more than one-half of their support OR
   *Between the ages of 19 and 23 at the end of the year, a full-time student and their earned income was not more than one half of their support.

A child is required to file a return if any of the following conditions apply for 2010:
• Unearned income exceeds $950;
• Earned income exceeds $5,700;
• Total unearned and earned income exceeds the greater of $950 or earned income (up to $5,400) plus $300.

When considering the child’s age at the end of the year, a child born on January 1, 1987 or before is considered to be 24 for purposes of a 2010 return and is not subject to the kiddie tax.

However, If the child is under 19 (24, if a full time student) as of December 31st and their only income is from interest or dividends totaling less than $9,500, the income may be reported directly on the parent’s return, using IRS Form 8814.

Although this option would prevent the need to file a return for the child, it may affect the parents return and tax liability in other areas. The parents may pay $95 more tax, for the $950 standard deduction on the child’s return, which would be taxed on the parent’s return at 10 percent. More importantly, various deductions on the parents return may be phased out or disallowed due to an increase in their income from the inclusion of the child’s income. Some of these areas are student-loan interest, individual retirement account (IRA) contributions, child tax credit, education credits or making work pay credits.

Ways to Minimize the Kiddie Tax
There are several strategies that may be used by taxpayers who have unearned income that could trigger the kiddie tax.

If a child between the age of 18 and 23 has earned income that is more than one half of their support, they are not subject to the kiddie tax. Support includes all amounts spent on food, lodging, clothing, medical expenses, education, recreation, transportation and similar necessities. Student loans in the name of the student are also considered to be support for which the child pays. However, if a child receives a scholarship, it is not considered support.

With some planning, earned income could be maximized to be greater than half of the child’s support, whether or not it is used for the support. This includes reasonable wages that self-employed parents pay to the student for services he or she performs.

Amounts subject to kiddie tax cannot exceed taxable income. A contribution to an IRA by a child who has earned income could reduce taxable income and thereby reduce or eliminate the kiddie tax.

The education credits may be used by some students to offset the kiddie tax. This is only the case when the parent cannot claim a student as a dependent.

Students could invest in tax-free investments, including section 529 plans, which are not included in income.