Former kiddie tax rules restored
The latest version of the kiddie tax, which was still in its infancy, was effectively wiped away when the Further Consolidated Appropriations Act, 2020, P.L. 116–94, was enacted at the end of 2019, thus nullifying changes that were included in the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115–97. This article explains how the kiddie tax calculations have changed once again, why Congress repealed the TCJA’s version of the kiddie tax, and how best to deal with these changes for children subject to this tax.
The latest amendments to the kiddie tax affect two separate time periods in slightly different ways. For 2020 and beyond, the kiddie tax returns to pre–TCJA rules wherein a child’s unearned income is taxed at the parent’s marginal tax rate. For 2018 and 2019, a child can choose between TCJA rules and pre–TCJA rules for computing the kiddie tax. Thus, the effect of this law change over these two periods is a wholesale repeal of the TCJA kiddie tax.
Before the TCJA, children subject to the kiddie tax computed tax on their net unearned income using their parents’ marginal tax rates. This “allocable parental tax” was spread across all the siblings in a family who were subject to the kiddie tax. Each child’s remaining taxable income was taxed using the individual child’s marginal tax rates. For over 30 years, this bifurcated tax computation negated any tax savings that might have resulted from the presumed shifting of unearned income from parents to their dependent children. We refer to this tax as the non–TCJA kiddie tax.
The TCJA eliminated the bifurcated tax computation for children subject to the kiddie tax. With the parents’ tax rates no longer relevant, the complexities of determining which tax rate to use for divorced parents or married parents who filed separately disappeared. Also, the allocable parental tax was no longer part of the TCJA’s kiddie tax, which further simplified tax calculations for children whose siblings were also subject to the tax. Under the TCJA, the tax for children subject to the kiddie tax was determined in a single complex calculation. These modifications resulted in higher taxes in many cases because the lower estate and trust income tax brackets are much narrower than those for individuals. We refer to this tax as the TCJA kiddie tax.
Given the steeply progressive nature of estate and trust tax rates, imposition of the TCJA kiddie tax had unintended consequences for Gold Star families. A Gold Star family is made up of the immediate family members of an individual who died while serving in the U.S. armed forces during a time of conflict. Gold Star spouses qualify for survivor benefits from both the Department of Defense (DOD) and the Department of Veterans Affairs (VA). Unfortunately, a federal rule against “double–dipping,” which dates to the 1970s, requires a dollar–for–dollar offset of benefits received from two federal sources. For Gold Star families, this offset is called the “widow’s tax.”
To combat the widow’s tax, Gold Star spouses intentionally transferred DOD benefits to surviving children in order to collect all the benefits paid by the VA. Since these children were not earning these payments in exchange for their labor, the DOD benefits were unearned income for purposes of computing the kiddie tax and were taxed at rates as high as 37% under the TCJA kiddie tax. This was in stark contrast to the non–TCJA tax on these benefits that was imposed at the marginal tax rate of the Gold Star spouse. Thus, congressional efforts to simplify the kiddie tax via the TCJA led to these unintended consequences for Gold Star families. While the impacts of the TCJA kiddie tax on Gold Star families were widely publicized, other affected taxpayers included Alaska residents who receive dividends from the Alaska Permanent Fund; Native Americans who receive tribal distributions; and low–income students who receive nontuition scholarships. Unfavorable press coverage of these consequences motivated Congress to change the kiddie tax once again.
The 2019 legislation returns the kiddie tax to its roots of taxing children’s unearned income at their parents’ marginal tax rates for tax years 2020 and beyond. Taxpayers can also elect the same treatment for tax years 2018 and 2019.
For 2019 tax returns that have not yet been filed (which may be many because of the COVID–19 pandemic and the extension of filing and payment due dates until July 15; see Notices 2020–18 and 2020–23), tax advisers will need to determine if their affected clients should pay the TCJA kiddie tax or elect to pay the non–TCJA kiddie tax instead. The same analysis should be done to determine if the 2018 tax returns should be amended. These analyses need to be done on a case–by–case basis since the TCJA kiddie tax brackets are unique to each child based on the mix of unearned and earned income included in the tax base.
Furthermore, these analyses should take into consideration whether the parents’ or siblings’ tax returns might need to be amended for changes to taxable income unrelated to the kiddie tax. If they are, the non–TCJA kiddie tax must take those amendments into account since the tax situations of parents and siblings can affect the computation of a child’s kiddie tax. Note that interest (but not penalties) will accrue if a child’s tax is recomputed and found deficient as a result of an adjustment to taxable income for either the child’s parent or a sibling (Temp. Regs. Sec. 1.1(i)-1T, Q&A 19).
The kiddie tax is reported on Form 8615, Tax for Certain Children Who Have Unearned Income. Tax software will compute the TCJA kiddie tax for 2019 since it is the general rule for that year. The 2019 Instructions to Form 8615 indicate that a taxpayer can elect to compute and pay the non–TCJA kiddie tax by writing “Election to modify tax of unearned income” either at the top of Form 8615 or on line 7 of Form 8615.
Alternatively, taxpayers can attach an election statement to their 2019 tax return. If an election is made, tax advisers will need to determine the steps required to ensure their tax preparation software is appropriately computing and reporting the non–TCJA kiddie tax. If their software has not been modified to provide for this election, worksheets in the Form 8615 instructions and the updated IRS Publication 929, Tax Rules for Children and Dependents, which has a posting date of March 20, 2020, can be used to compute the correct amount of tax.
Finally, if taxpayers choose to amend their 2018 tax returns, the non–TCJA kiddie tax can be computed using the amended 2018 instructions for Form 8615. Taxpayers can file Form 1040–X, Amended U.S. Individual Income Tax Return, for 2018 with the necessary election statement.
Whether taxpayers choose to pay the TCJA kiddie tax or the non–TCJA kiddie tax for 2019, some rules are consistent across both computations. The kiddie tax applies to children who do not file a joint return, have at least one living parent at the close of the tax year, have more than $2,200 of unearned income ($2,100 for 2018), and who are either (1) under age 18 or (2) are 18 (or a full–time student ages 19—23) and have earned income for the tax year equal to or less than one–half of their support. Taxable income is defined as gross income less allowable deductions.
Earned income and unearned income are defined the same across both calculations. Earned income includes amounts received as compensation for personal services as well as taxable distributions from qualified disability trusts. Unearned income includes income generated by property, such as interest, dividends, rents, and royalties, as well as certain nonproperty income like taxable Social Security benefits and taxable scholarships not reported on Form W–2, Wage and Tax Statement.
A dependent child’s standard deduction could be as small as $1,100 or as large as the standard deduction for single taxpayers ($12,200 for 2019). Net unearned income (NUI) plays a part in both tax computations. NUI for 2019 is defined as the excess of a child’s unearned income over the sum of (1) $1,100, plus (2) the greater of $1,100 or the child’s itemized deductions related to the unearned income.
Everything old is new again. In the face of political pressure, Congress repealed the TCJA kiddie tax for 2020 and beyond. Facts and circumstances will dictate whether taxpayers should pay the TCJA or the non–TCJA kiddie tax for 2019 and whether they should amend their 2018 tax returns to secure potential refunds.
About the authors
Kate Mantzke, CPA, Ph.D., is the Donna R. Kieso Professor of Accountancy. Brad Cripe, CPA, Ph.D., is the assistant department chair, the Gaylen and Joanne Larson Professor of Accountancy, and director of Graduate Studies and Accreditation. Suzanne Youngberg, CPA, MST, is an instructor and the MST adviser in the Department of Accountancy. They are all faculty members in the Department of Accountancy at Northern Illinois University in DeKalb, Ill.
To comment on this article or to suggest an idea for another article, contact Sally Schreiber, a JofA senior editor, at Sally.Schreiber@aicpa-cima.com.
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