Article: New Tax Law Increases "Kiddie Tax" Exposure

June 2007

New tax law increases “Kiddie Tax” exposure

For 2008 and beyond, the Kiddie Tax can potentially come into play until a child
turns 24

In late May, Congress passed another major piece of tax legislation, the Small Business and Work Opportunity Tax Act of 2007. President Bush signed it into law on May 25. The stated purpose of the new legislation was to provide small business owners with tax relief to help offset scheduled increases in the federal minimum wage.

However, the Act also includes revenue raisers, including unfavorable changes to the “Kiddie Tax” rules. While the changes don’t go into effect until next year, now is the time to undertake planning to reduce or eliminate the potentially higher family income taxes that could result from them.

Background. The Kiddie Tax curtails the ability of parents to significantly lower their family’s tax bill by transferring investment assets to low-taxed minor children. For 2007, a child under age 18 pays tax at his or her parent’s highest marginal rate on the child’s unearned (investment) income in excess of $1,700. However, the Kiddie Tax does not apply to a child who is married and files a joint return for the tax year. Unearned income within reach of the Kiddie Tax includes interest, dividends and capital gains.

Changes. If the Kiddie Tax applies to your child, part of his or her unearned income (typically from investments) will be taxed at your higher marginal federal rate rather than at your child’s lower rate. For 2008 and beyond, the Kiddie Tax can potentially come into play until the year during which a child turns 24. It finally cuts out for that year and for all subsequent years. More specifically, for 2008 and beyond, the Kiddie Tax applies only when all of the following four requirements are met. The first three requirements are the same as before the new law. The fourth requirement (the one having to do with the child’s age) was changed.

Living Parent Requirement. One or both of the child’s parents are alive at year-end and in a higher marginal federal income tax bracket than the child.
Filing Requirement. The child does not file a joint return for the year.
Unearned Income Requirement. The child’s unearned income for the year exceeds the annual threshold. For both 2006 and 2007, the threshold is $1,700. For 2008, it may be higher due to an inflation adjustment. If the child’s unearned income doesn’t exceed the threshold, the Kiddie Tax doesn’t apply. If the child’s unearned income exceeds the threshold, only the amount in excess of the threshold is hit with the Kiddie Tax. That means the excess income gets taxed at your higher marginal rate.
Age Requirement. Your child is (a) under age 18 at the end of the year, or (b) age 18 at the end of the year and doesn’t have earned income in excess of 50% of his or her support, or (c) age 19-23 at the end of the year, is a student, and doesn’t have earned income that exceeds half of his or her support.

The Kiddie Tax will apply if all four of these requirements are met for the year. It makes no difference if the child is claimed as a dependent on your return or anyone else’s.

Example 1. Melissa will be age 20 on December 31, 2008. Her earned income for 2008 doesn’t exceed half of her support, and she is a student for the year. Melissa falls under the third “age requirement.” Therefore, she will be subject to the Kiddie Tax if all of the three other requirements are also met for 2008.

Example 2: Now assume Melissa is not a student in 2008. In this case, she is exempt from the Kiddie Tax because none of the age rules apply to her. However, it could be a different story in 2009 through 2011 … if she goes to school.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.