The Internal Revenue Code contains a number of tax incentives to encourage college attendance. However, it also contains one “student tax” disincentive.
Sec. 1(g)(2)(A)(ii)—the student tax—was added as a revenue offset by the Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28. Starting in 2008, full-time students aged 19–23 whose earned income is less than half the cost of their support will be taxed the same as minors under age 19—at their parents’ marginal tax rate. The key difference between the student tax and the kiddie tax (Sec. 1(g)(2)(A)(i)) is that the student tax can be avoided by showing that the student’s earned income exceeds half of his or her support.
The student tax originated in February 2007 as a proposed new Sec. 1(h)(12), which would have limited the availability of the lowest capital gain rate (5%) to just one use for a family unit, including students under age 24. It was designed as a revenue offset for the Children’s Health Insurance Program (which was vetoed by the president). The student tax resurfaced in May 2007 as a revenue offset to an appropriations bill passed by the budget and appropriations committees, not the tax-writing committees. These committees simply applied the capital gain idea to all unearned income, not just capital gains and dividends. No explanation was given for the broader change.
The kiddie tax, when originally passed as part of the 1986 Tax Reform Act, taxed children under age 14 at their parents’ rate in order to curb the perceived abuse by “transfer [of] incomeproducing property to a child to ensure that the income is taxed at the child’s lower marginal rates” (H. Rep’t No. 99- 426, 99th Cong., 1st Sess., 801 (1985)). But the law’s reach applied to a child’s entire unearned income, not merely transfers from his or her parents.
Student Tax RulesThe student tax applies to students under age 24 “whose earned income . . . does not exceed one-half of the amount of the individual’s support” (Sec. 1(g)(2)(A)(ii)(II)). However, a married student who files a joint return with his or her spouse is not subject to the student tax (Sec. 1(g)(2)(C)). For these purposes, an individual must meet certain requirements to qualify as a student (see Sec.152(f)(2)).
The rules for calculating the student tax are the same as those for the kiddie tax and apply to the student’s unearned income over $1,800 (for 2008). If the investment income is ordinary income it is taxed at the parents’ highest marginal tax rate. If the investment income is net capital gain or qualified dividends, it is taxed at the applicable rate for the type of gain (applied as if the income were included in the parents’ return).
An unmarried student with no earned income will be trapped by the student tax. However, for students with earned income, there may be planning opportunities to keep the support amount below twice the earned income amount.
Avoiding the Support LimitThe term “support” includes food, shelter, clothing, medical and dental care, education, and the like. It is generally determined by the amount expended by the person furnishing such items (Regs. Sec. 1.152-1(a)(2)(i)). Support furnished in the form of property or lodging must be included at its fair market value. Nontaxable income, such as Social Security, is considered in determining support. Scholarships (as defined in Regs. Sec. 1.117-3(a)) are not considered in determining support (Regs. Sec. 1.152-1(c)).
Because the student tax is applied only when the student’s earned income is less than half the amount expended for the student’s support, the tax can be avoided by either increasing the student’s earned income or lowering the amount expended on his or her support. Students can increase earned income by taking a job or working additional hours at a job they already have. If a student’s parents have a business, they can increase the student’s earned income (and generate a deduction for the business) by hiring the student as an employee (however, the student’s pay must be reasonable). While it may be difficult to reduce a student’s support below a certain base level, a conscientious effort by the student to reduce his or her expenses can help. Careful documentation of a student’s income and expenses can be crucial to proving in close cases that the tax does not apply.
Challenges to the constitutionality of the kiddie tax have been few, and those have predictably been denied. Two district courts upheld the tax because only the tax rate, not the amount of the child’s tax, is determined by reference to his or her parents’ income (Butler, 798 F. Supp. 574 (E.D. Mo. 1992); Carlton, 789 F. Supp. 746 (N.D. Miss. 1991)). In both these cases, the children had investment income from funds received as a result of personal injuries, not from parental transfers. Based on this precedent, the student tax is also likely to be upheld if challenged.
Disclosure IssuesForm 8615, Tax for Children Under Age 18 with Investment Income of More Than $1,800, is used to compute the tax for children with investment income subject to taxation at their parents’ rate. It requires that the parents’ income be disclosed on the child’s return. There are uncooperative parents who will not supply their tax return information, and there should be privacy concerns about children seeing their parents’ income. Leaving this information blank may result in an e-filing rejection but it easily passes paper filing, provided that the correct tax at the parent’s rate is calculated.
The American Bankers Association has recommended that the IRS issue guidance allowing one of three options: (1) send the return to the IRS and let the agency calculate the appropriate tax based on the parents’ return; (2) give the child sufficient information from the parents’ income tax return, as permitted by Sec. 6103(e)(1)(A)(iii), to properly calculate the child’s applicable tax rate; or (3) establish default rules on the child’s tax when the parents’ information is not available (American Bankers Association Letter to Assistant Treasury Secretary Solomon and Chief Counsel Korb, 2008 TNT 117-23 (May 30, 2008)).
Should a preparer decide that his or her student client has met the half support from earned income requirement, he or she should consider the need to include a Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, regarding Temp. Regs. Sec. 1.1(i)-1T (and other regulations) to minimize the possibility of penalties under Sec. 6694(a). (See Hodes and Fernandez, “Form 8275 and Form 8275-R: How Much Information Is Enough?” 39 The Tax Adviser 428 (July 2008).)
Other ConsiderationsIn addition to determining whether a student aged 19–23 is subject to the student tax under Sec. 1(g)(2)(A)(ii), the amount of support (and who provided it) is also considered for purposes of the student’s dependency exemption. Students who provide over half of their support (even if half is not from earned income) are eligible to claim a personal exemption for themselves, as well as a full standard deduction. (This applies to children under age 19 as well.) Sec. 151(b) allows an exemption when the person is not the dependent of another. Sec. 63(c)(5) only limits the basic standard deduction for someone who is the dependent of another.
ConclusionThe 1954 committee reports gave “education incentive” as the reason for adding the over-age-19 student dependency exemption (S. Rep’t No. 1622, 83d Cong., 2d. Sess., 20 (1954)) so as not to create a hardship on parents when a child’s earnings that helped pay for college exceeded (then) $600. It is ironic that this same “student” theory has been used as the basis for creating an education disincentive when the earnings used to pay for college come from capital rather than labor.
Most unsettling is that a child up to age 23 (whether
or not a dependent or estranged) has the right under Sec.
6103(e)(1)(A)(iii) to obtain his or her parents’ tax return
information under the guise of complying with Sec. 1(g). That
could make for some interesting allowance negotiations.
John L. Miller is a faculty instructor at Metropolitan Community College in Omaha, NE. Jay Starkman is a sole practitioner in Atlanta, GA. The editor and contributors are all members of the AICPA Tax Division’s IRS Practice and Procedures Committee. For further information about this column, contact Mr. Miller at firstname.lastname@example.org.