Editor: Annette Nellen, Esq., CPA, CGMA
The Tax Cuts and Jobs Act (TCJA), P.L. 115-97, created many new challenges for both practice and education. Faculty are confronted not only with needing to be proficient with a new piece of legislation but also with developing effective means for helping students to understand the material. New law, however, creates an opportunity for the classroom: Professors can model for students how to deconstruct a change. This can reveal to students the various processes to understand not only the provision being examined currently but also other provisions they will encounter throughout the semester. In doing so, they gain the skills and abilities to be able to confidently embrace change throughout their careers.
The benefits of modeling a tax provision
Students need help understanding how to deal with the complexities of the tax law. They have been rewarded for memorization throughout their academic careers. When attempting to apply this practice in a tax course, students can become overwhelmed quickly by detail. They want to default to templates and worksheets rather than developing their own understanding. They also fail to understand that tax software, although extremely useful, is often flawed and its output needs verification. Students do not yet comprehend that, once they leave campus, they will need to be able to explain outcomes both within the firm and to clients, subsequently teach new hires, and eventually review and correct the work of others. Thus, faculty must assist students in creating techniques to manage detail and build comprehension.
A technique to help students understand the technical aspect of rules is to encourage them to take a scientific approach — build a model, then repeatedly test it to make sure it works. The schema can take one of several forms — decision tree, flowchart, or summary — depending on the topic and the student's learning style. Experimentation with different approaches should be encouraged. The focus should be on decision rules and how to identify key data triggers that suggest action. Once a model is in place, it should be applied to many scenarios to ensure viability.
This approach has three benefits. First, students should develop the confidence that they have a plan of attack for whatever might be asked on an exam. Second, students begin to see mistakes less as failures and more as opportunities to refine the model that they are conceiving. Third, and most importantly, students develop an understanding that transcends templates and worksheets, and create processes that allow them to check the accuracy of software outcomes.
Deconstructing the kiddie tax calculation into decision rules
As an example for modeling a difficult tax provision, consider the kiddie tax calculation, a topic the author chose to address early in the semester for three reasons. First, the semester begins by exposing students to key tax concepts, and the kiddie tax provides an interesting application of the assignment-of-income doctrine. Second, the kiddie tax can reinforce early learning of the tax equation, the use of rate schedules, and the use of preference rates. Third, the kiddie tax provision is an excellent starting point for learning to work with the Code, including the need to cross-reference other sections.
Historically, the kiddie tax calculation used the parents' marginal tax rates. Because the kiddie tax was designed to be a penalty, Sec. 1(g)(1) required the tax to be the greater of the tax computed on the child's taxable income using the single rates or the tax computed on the net unearned income using the parents' rates, plus the tax on the remaining income using the single tax rates. Although theoretically consistent with the concept that the unearned income is derived from assets shifted to the child by the parents, the computation of the tax on the net unearned income was unduly complex in two common cases. First, when the parents filed separate returns, Sec. 1(g)(5) required the use of the tax rates of the custodial parent when the parents were not married, or the tax rates of the parent with the higher taxable income when the parents were married but filing separately. Second, when the child had siblings, Sec. 1(g)(3)(B) required that the parents' rates be prorated across all the returns of the children subject to the kiddie tax.
In determining the tax on the net unearned income, the TCJA attempts to simplify the calculation by replacing the use of the parents' rates with the rates used to tax trust income. Sec. 1(j)(4) requires the melding of the trust and single rates both for ordinary income and preference income. In addition, Sec. 1(j)(4)(D) introduces the term "earned taxable income" and defines it as the part of the child's taxable income that is not net unearned income. In other words, the earned taxable income is the part of the taxable income that will be taxed using the single tax rates. The term "earned taxable income" is a misnomer, as this portion of the income may include both ordinary income and preference income, adding to the difficulty in understanding the provision.
Eliminating the need for the parents' rates allows each kiddie tax return to stand alone, significantly shortening Form 8615, Tax for Certain Children Who Have Unearned Income. However, the melding of the trust and single rates and the general untethering of the preference rates from the marginal rates results in most of the computations being off form, with several worksheets needed to compute the tax. Without an understanding of the intent of the provision and without decision rules to create a plan of attack, students will likely default to and fail to confirm software outcomes or mechanically plug data into worksheets, never grasping the intricacies of the provision. Instead, deconstructing the kiddie tax calculation into decision rules helps, particularly when it is built and demonstrated in class through a series of examples. The examples that follow assume that the child meets all the requirements for the kiddie tax, does not have any deductions for adjusted gross income (AGI), and does not elect to itemize deductions.
Example 1: Ordinary income
To ensure that students grasp the basic kiddie tax calculation, begin with ordinary income, where most textbook examples begin and end. Child A has wages of $5,000 and interest income of $10,000. The kiddie tax has three components: the determination of taxable income (Form 1040, U.S. Individual Income Tax Return), the computation of net unearned income (Form 8615), and the calculation of the tax (off the tax form, using rate schedules and preference rate worksheets). Earned income is derived from labor (i.e., wages). Any income source not specifically defined as earned income by Sec. 911(d) defaults to being unearned income. A's taxable income is calculated as shown in the table "A's Taxable Income" (below).
Sec. 63(c)(5) limits the standard deduction for a dependent to the greater of $1,100 (2019 indexed amount) or the combination of earned income, $5,000 in this example, and $350 (2019 indexed amount).
As shown in the table "A's Net Unearned Income" (below), gross unearned income is reduced for administrative convenience reasons (i.e., unearned income amounts deemed sufficiently small are not subject to the penalty tax) by two amounts, arrived at by reference to the current indexed amount for Sec. 63(c)(5)(A). However, this reduction, referred to in Sec. 1(g)(4)(A)(ii), is not named. So as not to confuse these amounts with the standard deduction, consider referring to the two amounts as the allowable amounts (i.e., the amounts allowed by Sec. 1(g)).
The first amount is a constant, $1,100 for 2019. The second amount is variable — either $1,100 if the child does not itemize or, if greater, the amount of the itemized deductions directly connected with the unearned income. The most common itemized deduction that would result in the second amount's increasing is state income taxes paid. This example assumes that the child does not itemize. Once students capture the basics presented in these examples, the model can be expanded to add decision rules to address what needs to happen if the child is able to itemize.
The child's taxable income is divided into two components. The first component, net unearned income, is the amount of the child's taxable income that will be taxed using the trust income tax rate schedule. For 2019, the first $2,600 is taxed at 10%, the next $6,700 is taxed at 24%, and the next $3,450 is taxed at 35%, with any remaining taxable income beyond $12,750 taxed at 37%. The second component, the earned taxable income, is simply the taxable income remaining after removal of the net unearned income. This is the amount taxed at the single tax rates. The flowchart "Calculating A's Total Tax" (below) shows how A's tax is calculated by separating the two categories of income.
The melding of the trust and single rates as dictated by Sec. 1(j)(4) is not needed here. The purpose of bringing together the trust and single rates is to ensure that the amount of taxable income in the 10% bracket does not exceed what would occur if all of the income were taxed at single rates. In other words, the amount taxed at 10% for 2019 cannot exceed $9,700. As will be demonstrated later, this will not occur unless the child has significant earned income. In this case, all of the earned income is eliminated by the standard deduction. The earned taxable income is the $2,200 of interest income eliminated from being taxed using the trust rates (i.e., the allowable amounts), further reduced by the $350 beyond earned income that is added to the standard deduction. Only when the earned income exceeds the single standard deduction will the child have earned income that is subject to tax.
Example 2: Preference income is less than net unearned income
Example 2 introduces qualified dividends. Child B has wages of $5,000, interest income of $10,000, and qualified dividend income of $15,000. The standard deduction, which is a function of earned taxable income, does not change. (See the table "B's Taxable Income and Net Unearned Income, below.)
All $15,000 of the qualified dividend income receives a preference rate. Although the Sec. 1(j)(4)(C) coordination of the preference rates appears to combine the trust and single preference rates, the practical purpose of the provision is to require that the preference income first be applied at the trust preference rates, with any remaining preference income receiving single preference rates. This allows the creation of a decision rule: If the dividend amount is less than or equal to the net unearned income, then all of the dividend is taxed using the trust preference rates.
The amount taxed using trust rates is $22,800, the net unearned income amount. Because all $15,000 of the dividends is taxed using the trust preference rates, the remaining income to be taxed using trust rates, $7,800, is ordinary income. For 2019, the first $2,650 of preference income in the trust is taxed at 0%, the next $10,300 is taxed at 15%, and the amount over $12,950 is taxed at 20%. The preference rates begin where the ordinary income leaves off. Thus, in this example, ordinary income of $7,800 eliminates the 0% bracket (i.e., the first $2,650 of taxable income) and half of the 15% preference bracket (i.e., the next $5,150 of taxable income), leaving $5,150 of dividends to be taxed at 15%. The remainder of the dividends are taxed at the 20% preference rate. All of the earned taxable income (i.e., the remaining taxable income) is ordinary income taxed using the 10% single tax bracket. The flowchart "Calculating B's Total Tax" (below) shows how B's tax is calculated by separating the two categories of income.
Example 3: Preference income is greater than net unearned income
Child C has wages of $5,000 and qualified dividend income of $25,000. The standard deduction, which is a function of earned income, does not change. Unearned income and taxable income remain unchanged from Example 2. All of the unearned income is now preference income. (See the table "C's Taxable Income and Net Unearned Income," below.)
All $25,000 of the qualified dividends receives the preference rate. The qualified dividends exceed the net unearned income of $22,800, resulting in all of the income that is taxed using the trust rates being treated as preference income. This produces the converse of the earlier decision rule: If the dividend amount is more than the net unearned income, then all of the income taxed using the trust rates is preference income, with the excess preference income becoming part of the earned taxable income. The portion of the preference income that becomes earned taxable income is taxed using the single preference rates, most likely 0%.
The wages of $5,000 were eliminated from tax by the standard deduction, leaving only qualified dividend income to be taxed. The allowable amounts eliminated $2,200 from being taxed using the trust preference rates. This amount, further reduced by the $350 addition to the standard deduction, defaults to earned taxable income. This amount is taxed at the single preference rate, 0% when the total income being taxed at the single rates is less than $39,375 for 2019. The flowchart "Calculating C's Total Tax" (below) shows how C's tax is calculated by separating the two categories of income.
Example 4: Earned income requiring rate schedule modification
In the previous examples, the trust rate schedule and the single rate schedule did not need to be melded. Students are encouraged to simplify data processing by paying attention to data triggers. Example 4 is used to demonstrate that the child must have significant earned income before the blending of the rates is triggered. Child D has wages of $18,000, interest income of $10,000, and qualified dividend income of $15,000. (See the table "D's Taxable Income" below.)
Earned income plus $350 exceeds the maximum standard deduction of $12,200 for 2019. Sec. 63(c)(5) limits the standard deduction, meaning that this provision cannot be used to increase the standard deduction beyond the single amount. (See the table "D's Net Unearned Income," below.)
Employing the earlier decision rule, the qualified dividends are less than net unearned income, resulting in all of the dividends being taxed using the trust preference rates. The remainder of the net unearned income and the earned taxable income are taxed as ordinary income.
The purpose of Sec. 1(j)(4)(B) is to ensure that the kiddie tax cannot be used to expand the amount of ordinary income taxed at 10% beyond what is accorded a single person. Thus, the amount of ordinary income taxed at 10% cannot exceed $9,700 for 2019. Ordinary income of $2,600 is taxed at 10% using the trust tax rates, leaving $7,100 to be taxed at 10% using the single rates. The flowchart "Calculating D's Total Tax" shows how D's tax is calculated by separating the two categories of income.
The melding of the trust and single rates need not be considered until earned income exceeds a threshold amount of $17,100 for 2019. To see how this figure is derived, note that earned income is eliminated from tax until the amount exceeds the $12,200 single standard deduction. Given that the first $2,600 of ordinary income that is part of the net unearned income would be taxed using the 10% trust rate, the ordinary income component of gross unearned income would need to be $4,800 (i.e., net unearned income of $2,600 after reduction by the $2,200 allowable amounts). Because of the allowable amounts, $2,200 of ordinary unearned income, sheltered from tax at the trust rates by the allowable amounts, would become earned taxable income taxed at the single 10% rate. Thus, another $4,900 of earned income would be needed to reach the 10% bracket limit of $9,700, or a total of $7,100 at the single 10% rate.
In other words, the earned income not eliminated by the $12,200 standard deduction would need to be $4,900, resulting in total earned income of $17,100. Thus, another decision rule can be created: If wages are less than $17,100, the need to meld the trust and single rates may be ignored. Note that $17,100 of earned income is a threshold. If the ordinary income component of the net unearned income falls below $4,800, then the earned income would have to increase in order to reach the maximum of $9,700 taxed at the 10% rate. The key here is to assist students in their decision processes by making them aware of data triggers and demonstrating to them how to derive these numbers.
A review of Table 1.7 from IRS Publication 1304, Individual Income Tax Returns 2016 (rev. September 2018), suggests that the need to meld the rates should be rare. Given that the threshold is earned income of $17,100 and ordinary unearned income of $4,800, AGI needs to be greater than $21,900 before there is a blending of rate schedules. Table 1.7 indicates that, for 2016, approximately 87% of the kiddie tax returns filed had an AGI of $20,000 or less. Although the IRS table does not provide any indication of kiddie tax amounts included in parents' income rather than as a stand-alone return, the determination is not affected by this option, which is available only when the child did not have earned income. Moreover, it is expected that some, if not most, of the kiddie tax returns with AGI above $20,000 would not have significant amounts of earned income. Taken as a whole, one would expect few kiddie tax returns with earned income greater than $17,100, making the melding of the trust and single brackets a nonfactor in most cases.
Developing useful skills
Tax law changes create opportunities in the classroom for faculty to demonstrate to students how to deconstruct a provision so that a model can be constructed based on the resulting decision rules and data triggers. The kiddie tax as changed by the TCJA is a good example for this exercise. Another suitable provision for this analysis is Sec. 199A.
After the class meeting, students are encouraged to use the examples and the decision rules to build their own decision tree or flowchart and then test their newfound model against numerous scenarios until they are convinced of the model's veracity. In doing so, students should become confident that they can accurately address any scenario that might arise on an exam, are not restricted to the use of complicated IRS worksheets, and have a means of quickly verifying software outcomes. More importantly, the students develop skills they can apply to understand the complexities of other tax provisions encountered once in the profession.
Contributors Dann G. Fisher, CPA, Ph.D., is a professor in the Department of Accounting at Kansas State University in Manhattan, Kan. Annette Nellen, Esq., CPA, CGMA, is a professor in the Department of Accounting and Finance at San José State University in San José, Calif., and is the chair of the AICPA Tax Executive Committee. For more information on this article, contact thetaxadviser@aicpa.org.
