Internal revenue code section 1(g) taxes unearned children’s income as if it belonged to the parents. This is known as the Kiddie tax. This income is taxed at the parents’ tax rates. Generally, the Kiddie tax rules apply to income of any child who is under age 18, turns 18, or is a full-time student who turns 19 – 23 before the end of the year.
Generally, children’s income is taxed as follows. The tax on the income of a child who is subject to the “Kiddie tax” rules is the greater of:
A. The tax that would be imposed if the Kiddie tax rules didn’t apply; or
B. The sum of:
I. The tax that would be imposed if the kiddie tax rules didn’t apply and if the child’s taxable income for the tax year was reduced by the child’s net unearned income (investment income minus twice the minimum basic standard deduction allowed to dependents, i.e., or 2 × $1,050 or $2,100), plus
II. The child’s share of the “allocable parental tax” (the tax on the child’s net unearned income that would be imposed if that net unearned income was included in the parents’ return).
For example, parents that are in the 25% income tax bracket can transfer a $22,000 bond to their 14 year old daughter, Jenny. The bond pays investment income at the 10% rate, which generates $2,200 per each year. Jenny’s net unearned income is $100. (The total amount $2,200, minus twice the standard deduction (2 × $1,050 or $2,100). This amount is taxable at the parents’ 25% rate so $25 in tax is due. The remainder of Jenny’s taxable income, $1,150 minus $100 or $1,050, is taxed at her 10% rate for a tax of $105. As such, Jenny’s total federal tax due is $130 in 2015. The good news is that the standard deduction amounts are adjusted for inflation so they should increase over time.
For planning opportunities where parents may avoid the application of the Kiddie tax and cut their over-all tax rate due, stay tuned for Part II – Avoiding the Kiddie tax. Or, contact a tax attorney at Ourednik Law Offices, P.A. to assist you with your tax planning as every family situation is different.