Hidden away in the legislative package that contained the SECURE Act was a provision that once again shifted the income tax rules that apply to the unearned income of minors—known as the “kiddie tax” system.
The 2017 tax reform legislation fundamentally changed the way that minors were taxed on unearned income—shifting from a system based on the parents’ tax rates to what was supposed to be a simplified system that used trust and estate income tax rates. For many, this change ironically ended up being one of the more complex and time-consuming provisions of the tax reform package.
Beginning in 2020, clients will be (retroactively) faced with a choice between tax systems for 2018 and 2019 and a reversion to the old system going forward—meaning that all clients with children should, once again, be given a refresher course in the rules.
The Fix for the Kiddie Tax
Under the 2017 tax reform legislation, the unearned income of minors was to be taxed based upon the rates applicable to trusts and estates, and the earned income to be taxed at the rates applicable to single filers. Prior to tax reform, income subject to the kiddie tax rules (i.e., certain unearned income of minors) was taxed at the parent’s income tax rate. These kiddie tax rules are generally designed to prevent parents from trying to shift income to their children, who are generally subject to much lower tax rates on their own.
The change over to the trusts and estates rate was controversial because it had the potential to subject the unearned income of minors to higher tax rates than the parents. The income tax brackets for trusts and estates are much smaller than those that apply for individuals—in 2020, the top 37% tax rate begins at $12,950 for trusts and estates and $622,050 for married couples filing a joint return.
Under the SECURE Act, the changes made by the 2017 tax reform legislation with respect to the kiddie tax rules were repealed so that the parents’ rates will once again apply beginning in 2020. Essentially, this means that the first $1,100 of a minor’s unearned income will be received tax-free and the second $1,100 of a minor’s unearned income will be subject to the child’s income tax rates. Any income above the $2,200 level will be taxed according to the parents’ rate schedule.
Kiddie tax rules only apply to minors with at least one parent living at the end of the tax year. The kiddie tax also apply to children between age 18 and 24 if the child is enrolled in school full-time and does not have earned income that provided for at least half of their support that year.
While the repeal of the 2017 kiddie tax changes is effective beginning in 2020., taxpayers have the option of electing to have either set of rules apply retroactively, in 2018 and 2019.
Running the Math on the Kiddie Tax for 2018 & 2019
Clients whose children have unearned income for 2018 or 2019 may wish to run the math to determine which set of rules results in the lower tax liability. Children who can be claimed as dependents are entitled to a standard deduction that equals the greater of (1) $1,100 or (2) $350 plus the minor’s earned income. When calculating the kiddie tax, $2,200 ($1,100 untaxed and $1,100 taxed at the child’s rate) is essentially subtracted out as an exemption.
For parents of children with relatively moderate levels of unearned income, the kiddie tax changes were not dramatic. However, clients with children receiving substantial levels of unearned income—whether from investments in the form of dividends from a family’s closely held-business, stocks, bonds and even the taxable portion of certain scholarship awards—will want to run the numbers based on both the trusts and estates tax rate and their own income tax rate for the year in question.
For many clients whose children had substantial unearned income for 2018 or 2019, electing to revert back to the parents’ tax rate will require an amended tax return. The IRS has yet to release any specific guidance to the contrary providing an alternative solution or relief.
Running the numbers will help clients with children determine the best course of action for 2018 and 2019—but going forward, substantial unearned income of minors will once again be taxed at the parents’ tax rates.