Kiddie Tax May Be Due on College Scholarships

The "kiddie tax" rules, under which dependent children's unearned income is taxed at the parents' higher tax rate, have long applied to unearned income in excess of an amount indexed to inflation ($1,050 for 2016). Congress passed this rule as part of the Tax Reform Act of 1986 (TRA), P.L. 99-514, to thwart the shifting of income-producing assets among family members to reduce federal income tax (S. Rep't No. 99-212, 1986; H.R. Rep't No. 99-426, 99th Cong., 1st Sess. (1985)).

However, the TRA defined unearned income to include anything except Sec. 911 earned income, rather than investment income. Earned income is defined in Sec. 911(d)(2)(A) as

wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered, but does not include that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation which represents a distribution of earnings or profits rather than a reasonable allowance as compensation for the personal services actually rendered.

Consequently, the taxable portion of college scholarships may be unearned income and subject to the kiddie tax.

In 1986, this was not a material issue because, when it was enacted, the law applied only to children under 14 years of age. Now that the age has been raised to children under 24 for certain full-time college students, the blessing of a scholarship may come with an unanticipated tax shock and requires CPAs to consider this wrinkle in tax planning. Beginning with 2013 returns, the IRS changed the title of Form 8615 from Tax for Certain Children Who Have Investment Income of More Than $1,900 to Tax for Certain Children Who Have Unearned Income. Similarly, the instructions for the form were changed to include taxable scholarship and fellowship grants not reported on Form W-2, Wage and Tax Statement.

To be clear, Sec. 117 allows scholarships for tuition and fees required for attendance and other fees and expenses required for courses to be excluded from federal income tax, including the kiddie tax. However, scholarships that help defray the other costs of attendance, such as room and board, were and continue to be taxable.

Taxpayers may be confused by the application of the kiddie tax to scholarships because Sec. 63(c)(5) (the standard deduction for dependents), Sec. 6012 (persons required to file a return), and Prop. Regs. Sec. 1.117-6 (qualified scholarships) all treat the taxable portion of scholarship income as earned income. Also, the plain meaning of "scholarship" often implies that it is earned; the Oxford University Press's online Oxford Dictionaries' definition of scholarship is "a grant or payment made to support a student's education, awarded on the basis of academic or other achievement." Nonetheless, that is not how the Code was written, and it is not how the IRS appears to be interpreting it. While taxable scholarship income is affected, it is not alone. Royalty income that children earn (e.g., from science fair inventions they patent) is also taxed as unearned income. As such, CPAs might want to proceed cautiously with any noninvestment income received by children.