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The “kiddie tax” was added to the tax code in 1986 to discourage parents from shifting income to their children in order to reduce the family’s tax liability. It effectively eliminated the benefits of income-shifting by taxing all but a small portion of a child’s unearned income at the parents’ marginal tax rate.

Under the Tax Cuts and Jobs Act (TCJA), the kiddie tax has become even harsher for many families: Now, a child’s unearned income is taxed according to the tax brackets for trusts and estates, under which the highest tax rates kick in at far lower income levels. For example, the highest tax rate — 37% — applies when a child’s taxable unearned income tops $12,500. In contrast, for a married couple filing jointly, that rate doesn’t apply until their taxable income reaches $600,000.

This means that, in some cases, children will be subject to higher tax rates than their parents. (See the table below for a comparison of the tax brackets for individuals, joint filers and trusts and estates.) Fortunately, there are strategies you can use to shift income to children in lower tax brackets without triggering the kiddie tax.

Background

Transferring investments and other income-producing assets to your children can be an effective estate-planning technique. Not only are the assets removed from your taxable estate, but any income they generate is taxed at your child’s presumably lower tax rate. The Tax Reform Act of 1986 introduced the kiddie tax in an effort to recover this lost tax revenue. If the kiddie tax applies, all of a child’s unearned income above a specified threshold (currently, $2,100) is taxed at the kiddie tax rate (originally, the parents’ marginal rate; now, the trusts and estates rate) — assuming it results in a higher tax than the child would pay without the kiddie tax.

Originally, the kiddie tax applied to children under 14, but in 2007 Congress expanded the tax to include all children age 18 or younger plus full-time students age 19 to 23. The tax doesn’t apply, however, to 1) children who are married and file joint returns with their spouses, or 2) children age 18 or older whose earned income exceeds half of their living expenses.

Impact of the Tax

Before the TCJA, the kiddie tax simply erased the benefits of income shifting. But in its current form, the tax can often be punitive. For example: Dave and Ann are a married couple filing jointly with taxable income of $300,000 per year. They transfer several investments to their 18-year-old daughter, Julia, which generate $20,000 in income annually. As the table below indicates, if the kiddie tax didn’t apply (and assuming her total taxable income is less than $38,700), Julia would be in the 12% tax bracket. Under the pre-TCJA kiddie tax rules, and using the current brackets, Julia’s unearned income would be taxed at Dave and Ann’s marginal rate of 24%. But under the current version of the kiddie tax rules, which apply the estate and trust brackets, most of Julia’s income is taxed at 35% or 37%.

Avoiding the Tax

There are several potential strategies for avoiding the kiddie tax while still taking advantage of income-shifting benefits. They include:

Delaying Investment Income

The kiddie tax ceases to apply in the year your child turns 19 (24 for a full-time student). So you can avoid kiddie tax by delaying investment income until your child reaches the applicable age. For example, you might transfer investments that emphasize capital appreciation over current income — such as growth stocks, unimproved real estate, or interests in closely held businesses that pay little or no cash dividends. Or you might give your child savings bonds that offer deferral of income until the bonds mature or are cashed in.

Using Tax-Exempt Investments

Income on tax-exempt municipal bonds or bond funds is exempt from all income taxes, including the kiddie tax. One advantage of this strategy over income deferral is that your child can use the income for tuition or other expenses. Other options include 529 plans and Coverdell Education Savings Accounts, which offer tax-deferred growth and tax-free withdrawals for qualified educational expenses.

Increasing Earned Income

Remember, the kiddie tax applies only to unearned income. Income your child earns from a job is taxed at the child’s tax rate, and earnings up to the standard deduction (currently, $12,000) are tax-free. Plus, if your child is 18 or older and has enough earned income to cover more than half of his or her living expenses, the kiddie tax doesn’t apply to any of the child’s income, earned or unearned.

If you own a business, consider hiring your child. Doing so increases the child’s earned income and, so long as the wages are reasonable, your business gets a deduction. And if your child is under 18 and your business is unincorporated, this strategy avoids payroll taxes on your child’s wages and reduces self-employment taxes.

Taking these two steps may help avoid confrontations and place interested parties on notice that you’ve addressed the situation. The mere fact that you’ve taken action will be recognized in your favor. Contact us if you’re concerned that your will may someday come under an undue influence claim.

2018 Tax Brackets

Ordinary Income

Long-Term Capital Gains

© 2018