The Kiddie Tax: Inequitable Consequences and the Need for Reform

By Gerri B. Chanel, CPA, MBA

EXECUTIVE
SUMMARY

Photo by ChrisDorney/iStock

  • The kiddie tax was added by the 1986 Tax Reform Act to prevent parents in higher tax brackets from avoiding tax on income from investment assets by transferring them to their children.
  • Under the kiddie tax rules, a child under a specified age (originally 14) at the end of a tax year must pay tax on unearned income over a specified amount at the higher of the child's marginal tax rate or his or her parent's marginal tax rate.
  • In 2006 and 2007, the law was amended so that the kiddie tax now applies to dependents up to age 18 and up to age 23 if they are full-time students. The income threshold for the tax is $2,100 for 2015.
  • From the beginning, the kiddie tax rules have been criticized because they cause complexity for taxpayers, create economic distortions and savings disincentives, and fail to effectively prevent income shifting.

The "kiddie tax" was enacted in 1986 as what was intended to be a simple-enough mechanism to prevent a small number of wealthy parents from shifting income-producing assets to young children who were in lower tax brackets. Application of the tax quickly led to what some have called unintended consequences, though, in fact, they were not: The law's crafters clearly were aware of possible inequitable outcomes.

Over the years, as the age limit for the tax has increased from 14 to 18 and up to 23 for full-time students, so too have the problems of inequity. The repeated raising of the age limit has also led to problems of complexity and confidentiality that were unlikely to have occurred with a 14-year-old. This article addresses the problems caused by the increases in the age at which the kiddie tax applies and explains why, as the kiddie tax heads toward its 30th birthday, it is time for Congress to reform it.

From Kiddie Tax to Student Tax

The kiddie tax was added by the Tax Reform Act of 1986 (TRA), 1 the goal of which was to simplify the tax system and reduce tax rates overall, while broadening the tax base by eliminating tax shelters and other loopholes. Among its many other provisions, the TRA modified the taxation of children by eliminating the personal exemption for taxpayers who could be claimed as dependents on another's return and by limiting the standard deduction of these taxpayers to the greater of $500 ($1,050 for 2015) or $250 ($350 for 2015) plus the taxpayers' earned income. 2

The TRA also introduced the "kiddie tax" to target wealthy parents who were shifting income-producing assets to their children, who were usually subject to lower tax rates. The new Sec. 1(i) (later changed to Sec. 1(g)), applied to tax years beginning after Dec. 31, 1986, and provided that, for any child who was under age 14 at the end of the tax year, any unearned income of the child over $1,000 would be taxed at the higher of the child's marginal tax rate or the parent's.

By the end of 2005, the exemption from the kiddie tax had risen from $1,000 to $1,600, 3 and other minor changes to the tax had been made. In May 2006, a major change occurred as Congress passed the Tax Increase Prevention and Reconciliation Act, 4 raising the application of the kiddie tax from under age 14 to under age 18, effective for 2006. Just a year later, the Small Business Work Opportunity and Tax Act of 2007 5 raised the age to under 19, or under 24 for full-time students. It is likely that both changes were simply to raise revenue, since the committee reports for both pieces of legislation give no reason for the change.

The choice of age 14 in the 1986 legislation was not arbitrary; it was based on specific reasons described below. However, the original legislative intent was lost with the subsequent increases in age. According to a 2010 report by the President's Economic Recovery Advisory Board, 6 about half of kiddie tax filers at that time were college students, and about 40% were between age 14 and 18, meaning that only 10% of the filers were those envisioned by the original legislation.

Complexity

The kiddie tax legislation of 1986 was originally proposed early in the legislative process that led to the passage of the 1986 Internal Revenue Code, appearing in a November 1984 proposal, Tax Reform for Fairness, Simplicity, and Economic Growth: The Treasury Department Report to the President. From the start, the proposed kiddie tax focused on age 14 for two reasons. First, according to the report, it was "the age at which children may work in certain employment under the Fair Labor Standards Act." 7 Second, the choice of age 14 was an attempt to minimize complexity.

According to Victor Thuronyi, one of the legislation's drafters, "the assumption was made that a number of children above age 14 might have substantial earned income and accordingly would have substantially more complicated financial situations than, say, the typical three-year-old." 8 And while he acknowledged that applying the rules might be complex in some individual cases, he said that the tax was aimed at a small group of taxpayers who would be "well able to handle this complexity." 9

Almost immediately after enactment of the kiddie tax—and years before the age was raised—there were calls, albeit unheeded, to reduce its complexity, 10 and the Senate Finance Committee held a hearing on the issue in 1999. The later increases in the age from 14 to 23 caused an explosion in the numbers of taxpayers required to deal with the complexity. While there is no exact way to measure that complexity, it is telling that the ­34-page IRS Publication 929, Tax Rules for Children and Dependents, devotes over half of its pages, rife with worksheets, to the taxation of dependents with investment income.

Complexity begins with the option for parents to "simplify" matters by allowing them to include the child's income on the parents' own return instead of filing a separate return for the child. 11 First, the option permitting parents to include the income on their own returns has limits that taxpayers must identify: The child's investment income can consist of only interest, dividends, and certain capital gain distributions, and it cannot exceed a certain limit that changes from time to time. In addition, no estimated tax payments can have been made in the child's name, and the child must not be subject to backup withholding.

And the election to include the income on the parents' return may have negative tax consequences. If the child received qualified dividends or capital gain distributions, the election may result in a higher tax than if a separate tax return for the child was filed. Another downside of the parents' choosing this "simplified" option, is that it might increase the parents' adjusted gross income (AGI) to the extent that it may increase the phaseout of deductions and credits on the parents' return that are based on their AGI. It can also reduce IRA contributions, which are limited based on the taxpayer's AGI, 12 and increase the amount of Social Security benefits that are subject to tax.

Filing a separate return for the child offers its own set of complexities. Two sets of calculations must be done: one for the ordinary tax liability and one for the kiddie tax liability. For parents with more than one child, allocations are required to determine the kiddie tax attributable to each child. 13 The filing process itself also becomes complicated. A child with a "simple" return cannot file until the parents' return is filed. Gathering sibling information can be difficult, particularly if children are away at college or elsewhere. Moreover, if the parents file their income tax return on extension, the child(ren)'s return(s) must be extended as well. If any one of these returns is later amended, all may have to be amended.

Compliance is further complicated for parents who are unmarried, separated, remarried, or treated as unmarried for tax purposes, because it is more difficult to determine the amount of parental income to be used to calculate the tax.

Unintended Consequences and Inequitable Outcomes

And what of a child's income that is not a result of income-shifting from a parent, such as income from inherited property or property received from someone other than a parent? The Senate version of the 1986 legislation had addressed those circumstances by making a distinction between parental- and nonparental-source income rather than earned vs. unearned income. Only "parental-­source" income would have been subject to the tax. 14 Property received from nonparental sources and property received by reason of the death of a parent or stepparent (qualified segregated assets), as well as income from qualified segregated assets, would have been considered derived from nonparental sources under the Senate bill.

The bill further specified that indirect transfers could not be used to escape the tax—for example, if a parent transferred assets to the child's grandparent, who in turn transferred assets to the child. Both the House Ways and Means Committee and the Senate Finance Committee bills contained this provision, but Thuronyi indicated that "the staffs unanimously considered the [qualified segregated assets] to be an administrative and compliance nightmare and ultimately reason prevailed on this point in conference." 15

The decision to avoid the administrative and compliance difficulties that limiting the tax to nonparental source property would entail was also a legislative decision to accept the inequitable consequences that would result. Thus, the kiddie tax applies even in circumstances in which tax avoidance could not have been a motive; for example, a gift from a grandparent who is in a tax bracket lower than both the child or the parents 16 or a situation where a child receives a large insurance settlement due to a physical injury.

Even Social Security benefits can be drawn into the net if taxable, and this is not at all an unintended consequence. The preamble to temporary regulations issued in 1987 provides that: "the tax under section 1(i) applies to net unearned income . . . unearned income includes social security and pension payments received by a child to the extent such amounts are included in the child's adjusted gross income." 17

The increase in the age the kiddie tax applies to from 18 to 23 introduced additional inequities. Since the original intent of the law contemplated the "simple" tax situation of those under age 14 who usually did not have earned income, it did not need to address the effects of the types of unearned income that might accrue to an 18- to 23-year-old. As a result, items of income such as unemployment benefits, investment income from a child's investments of his or her own earnings, and taxable scholarships can be subject to the tax.

Parent Confidentiality

Thuronyi also indicated that a third reason for the age 14 cutoff was to "preclude the argument that many children subject to the kiddie tax might have left home and hence would not properly be considered part of the family unit as a matter of principle and as a matter of convenience in tax return preparation." 18 This logic falls far short for the many 18- to 23-year olds who live at home only temporarily, if at all (the fallout of the 2008 financial crisis notwithstanding).

The original drafters of the kiddie tax legislation also considered the issue of confidentiality of a parent's tax situation, stating in the November 1984 Treasury Report that:

In most cases the income tax return of a child under 14 years of age is prepared by or on behalf of the parent and signed by the parent as guardian of the child. In such cases, the requirement that a child's income be aggregated with that of his or her parents would not create a problem of confidentiality with respect to the parents' return information, since there would be no need to divulge this information to the child. 19

A 21-year-old student, on the other hand, would generally be required to sign his or her own return—and might be quite curious about family finances, a topic the parents of a young adult might wish to avoid for valid reasons.

Additional confidentiality concerns can arise when parents are separated, since the kiddie tax must be computed by reference to the parent with the higher income, even if the other spouse has physical custody of the child. This may require sensitive financial information to be provided by one spouse to the other.

Overhaul Needed

Some critics of the kiddie tax call for simplification while others call for more equity in its application. Still others call for a complete overhaul, pointing out weaknesses that range from the tax's failure to prevent the transfer of appreciated property to children to its creation of economic distortions and savings disincentives. 20

Proposals for reform began almost from the beginning. Leo Schmolka proposed in 1987 (1) that the tax apply based on whether a child qualified as a dependent, not on age, and (2) that those dependents be taxed at the same compressed rate structure as estates and trusts. 21 Nevertheless, the application of the tax as originally conceived has only continued to expand as the applicable age has increased. In 2010, President Barack Obama's Economic Recovery Advisory Board indicated that reform was needed, offering several options. 22

First, the board indicated that hundreds of thousands of returns yielding little or no tax could be avoided by raising the standard deduction for dependents and by providing safe-harbor withholding exemptions for young filers. Second, further simplification was suggested by eliminating any interaction with siblings' income. The board's third proposal was to change the tax rate that would apply, with one option being to use the compressed rate schedule for fiduciary returns, similar to Schmolka's proposal almost 25 years earlier.

In 2011, Samuel Brunson offered more qualitative suggestions. First, he suggested that instead of bifurcating income between earned and unearned, the tax should divide a child's income between income earned on assets received as a gift (regardless of source) and all other income. And it would apply to assets received while the child was subject to the tax rather than just to the income realized during that time, thus capturing the income on the transfer of appreciated property. 23 Brunson proffered that this scheme would eliminate the disincentive for children to save since the kiddie tax would not apply on investment income from their own savings.

In February 2014, the House Ways and Means Committee released draft legislation titled the Tax Reform Act of 2014. 24 The proposal would simplify the kiddie tax by effectively applying the rates applicable to trusts to the net unearned income of a child subject to the tax—interestingly, the same suggestion that Schmolka made in 1987. However, the 2014 proposal includes no provisions to alter the nature of income subject to the tax or other recommendations for change. This proposed legislation was issued only as a discussion draft and was never formally introduced as a bill; it remains to be seen if it will be taken up by the current Congress.

Other than this provision in the draft Tax Reform Act of 2014, there appears to be no action currently in the offing to modify the kiddie tax. But, by any analysis, given the tax's complexity, unintended consequences, and inequitable outcomes, it is time for Congress to fix the kiddie tax.

Footnotes

1 Tax Reform Act of 1986, P.L. 99-514.

2 Sec. 63(c)(5); Rev. Proc. 2014-61.

3 Rev. Proc. 2004-71. It is $2,100 for 2015 (Rev. Proc. 2014-61).

4 Tax Increase Prevention and Reconciliation Act, P.L. 109-222.

5 Small Business Work Opportunity and Tax Act of 2007, P.L. 110-28.

6 President's Economic Recovery Advisory Board, The Report on Tax Reform Options: Simplification, Compliance, and Corporate Taxation (August 2010).

7 Treasury Department, Tax Reform for Fairness, Simplicity, and Economic Growth: The Treasury Department Report to the President,Vol. 2, pp. 94–95 (1984).

8 Thuronyi, "The Kiddie Tax: A Reply to Professor Schmolka," 43 Tax Law Review 589, 599 (1988).

9 Id.

10 See, e.g., Schmolka, "The Kiddie Tax Under the Tax Reform Act of 1986: A Need for Reform While the Ink Is Still Wet," 11 Review of Taxation of Indiv iduals 99 (1987).

11 Sec. 1(g)(7).

12 Sec. 219(g).

13 Publication 929, Tax Rules for Children and Dependents, p. 19 (2013).

14 See S. Rep't 99-313, p. 863.

15 Thuronyi, "The Kiddie Tax: A Reply to Professor Schmolka," 43 Tax Law Review 589, n.3 (1988).

16 See discussion in Beck, "The Kiddie Tax: A Nuisance Solution to a Non-Existent Problem," 30-1 Family Law Quarterly 103 (1996).

17 T.D. 8158, 52 Fed. Reg. 33577 (Sept. 4, 1987).

18 Thuronyi, "The Kiddie Tax: A Reply to Professor Schmolka," 43 Tax Law Review 589, 599 (1988).

19 Treasury Department, Tax Reform for Fairness, Simplicity, and Economic Growth: The Treasury Department Report to the President, Vol. 2 (November 1984).

20 See Beck, "The Kiddie Tax: A Nuisance Solution to a Non-Existent Problem," 30-1 Family Law Quarterly 103 (1996); Brunson, "Grown-Up Income Shifting: Yesterday's Kiddie Tax Is Not Enough," 59 Kansas Law Review 457 (2011).

21 Schmolka, "The Kiddie Tax Under the Tax Reform Act of 1986: A Need for Reform While the Ink Is Still Wet," 11 Review of Taxation of Individuals 99 (1987). The AICPA made a similar suggestion regarding the use of the estate and trust income tax rates in a letter to members of the House Ways and Means Committee's Tax Reform Working Group on Education and Family Benefits on April 11, 2013.

22 President's Economic Recovery Advisory Board, The Report on Tax Reform Options: Simplification, Compliance, and Corporate Taxation (August 2010).

23 Brunson, "Grown-Up Income Shifting: Yesterday's Kiddie Tax Is Not Enough," 59 Kansas Law Review 457, 487 (2011).

24 Tax Reform Act of 2014, §§1001, 1101, H.R. ___, available at waysandmeans.house.gov.

Contributor

Gerri Chanel is an associate professor of accounting and taxation at York College of the City University of New York. For more information about this article, contact Prof. Chanel at gchanel@york.cuny.edu.

 

Newsletter Articles

SPONSORED REPORT

Year-End Tax Planning and What’s New for 2016

A look at year-end tax planning strategies for individuals and businesses, as well as recent federal tax law changes affecting this year’s tax returns.

PRACTICE MANAGEMENT

CPAs Contend With Tax ID Theft

Tax-related identity theft fraud remains a widespread problem that is often difficult for victims and their tax preparers to correct.