The changes made by the 2017 tax law – referred to as the Tax Cuts and Jobs Act (TCJA) – subjected a child’s unearned income to the estate and gift tax rates. Previously, the “kiddie tax” applied the parents’ marginal tax rate to a child’s unearned income in excess of a certain threshold ($2,200 in 2020).

In late 2019, Congress reversed the TCJA changes to the federal kiddie tax that it had made only two years before. The TCJA rules actually pushed some children into a higher tax bracket than their parents.

Disincentive for income shifting

Established in 1986, the kiddie tax was designed as a disincentive to income shifting by parents who, to reduce their tax bills, transfer income-producing assets to their children in lower tax brackets. By taxing a child’s unearned income over a specified threshold ($2,100 in 2018 and $2,200 in 2019 and 2020) at the parents’ marginal rate, the kiddie tax essentially eliminated the advantages of income shifting. In other words, except for a small amount taxed at the child’s rate, most of the income was taxed as if a transfer had not been made.

Originally, the kiddie tax applied to children under 14, but in 2007 the age threshold was raised to 19 (24 for full-time students) as of the last day of the tax year. The tax does not apply to children who are married and file joint returns or are 18 or older with earned income that exceeds half of their living expenses.

Harsh consequences

By imposing kiddie tax at trust and estate rates, the TCJA created some harsh outcomes. That is because for trusts and estates the highest marginal rates kick in at very low-income levels. For example, in 2018 trusts and estates were subject to the highest rate, 37%, on ordinary income or short-term capital gains over $12,500. Long-term capital gain income over $12,700 was subject to 20%. In contrast, the thresholds for married couples filing jointly were $600,000 for ordinary income and $479,000 for long-term capital gain and qualified dividend income.

Related Read: Kiddie Tax: New Hazards, New Opportunities

Say a married couple with $250,000 in taxable income made a substantial gift of income-producing assets to their child in 2018. Income that exceeded the $12,500 and $12,700 thresholds would be taxed at 37% for ordinary income and short-term capital gains and 20% for long-term capital gains and qualified dividends. The married couple would have been taxed at rates of 24% and 15%, respectively, on the same income.

The TCJA kiddie tax was particularly unfavorable for children of deceased military personnel, first responders and emergency medical workers who received certain government benefits. Because these benefits were considered unearned income, they were taxed at rates as high as 37%, even if the surviving parent was in a lower bracket, such as 22% or 24%.

To avoid such unintended consequences, the SECURE Act reinstated the pre-TCJA kiddie tax rules, effective for tax years beginning in 2020. It also gave families the option of applying the old rules on their 2018 and 2019 returns. (See below: Should You Amend Your Children’s Returns?)

Planning for the future

Before you make financial gifts to your children, consider the impact of the kiddie tax. The SECURE Act made the tax more palatable than it was, but it still could thwart your tax-planning goals. For children subject to the kiddie tax, you might consider postponing gifts until they exceed the age thresholds. Alternatively, you could make gifts that will not — or are less likely to — trigger the tax, such as growth (as opposed to income) investments, tax-exempt or tax-deferred bonds and contributions to Section 529 college savings plans.

Related Read: The SECURE Act Likely to Affect Your Retirement and Estate Plans

Sidebar: Should you amend your children’s returns?

If your children paid kiddie tax in 2018 or 2019, filing an amended return could be beneficial. Taxpayers may apply the TCJA rules or pre-TCJA rules for those years. Even though the SECURE Act was passed before the 2019 filing deadline, many tax software programs calculated kiddie tax for 2019 under the TCJA rules.

To determine whether you should file amended returns, your ORBA tax advisor can calculate your child’s tax liability under both sets of rules. Many families find that they are better off using the pre-TCJA rules and that it would pay to amend returns that followed the TCJA rules. But the TCJA rules do not always result in higher taxes. At lower levels of your child’s unearned income, the TCJA rules may produce tax savings.

Suppose, for example, that in 2018 a married couple in the 32% tax bracket gave their child an investment that earns ordinary income. Using pre-TCJA rules, unearned income beyond the $2,100 threshold would be taxed at 32%. But using TCJA rules, it would be taxed according to the trust and estate rates as follows:

• Up to $2,550, 10%;
• The next $6,600, 24%;
• The next $3,350, 35%; and
• Any income above $12,500, 37%.

So, depending on the amount of income, the TCJA rules may save taxes.

Talk to your ORBA tax advisor to explore options that make the most sense given your family’s circumstances.

For more information, contact Thomas Vance at 312.670.7444. Visit orba.com to learn more about our Wealth Management Services.