Randy Gardner, J.D., LLM, CPA, CFP®, is the founder of Goals Gap Planning LLC in Laguna Beach, CA.
Julie A. Welch, CPA, PFS, CFP®, is a shareholder with Meara Welch Browne, P.C. in Leawood, KS.
The tax cuts and Jobs Act made several changes to the way dependent children’s earned and unearned income are taxed for the years 2018 to 2025. Many of the provisions remain unchanged, but several of the changes can be extremely helpful in reducing a family unit’s taxes.
Who is treated as a dependent child? Under 2018 law, the definition of a dependent child remains unchanged and includes any child of the taxpayer who is: (1) under the age of 18; (2) under the age of 19 and does not provide more than half of his or her own support with earned income; or (3) under the age of 24, a full-time student, and does not provide more than half of his or her own support with earned income.
When talking about the taxation of children, it is important to distinguish earned income and unearned income.
Earned income means wages, tips, and other amounts received as compensation for personal services, but does not include corporate distributions of earnings and profits. If the child is a sole proprietor or a partner in a trade or business in which capital is not an income-producing factor—such as babysitting or a dog-walking business—and the child’s personal services produced the business income, all of the child’s gross income from the trade or business is considered earned income. If both personal services and capital are material income-producing factors, such as a manufacturing business, then a reasonable allowance for compensation for personal services up to 30 percent of the child’s net profits could be treated as earned income.
Unearned income is generally investment income such as interest, dividends, and capital gains.
Earned Income Planning Opportunities
Dependent children with earned income are generally better off under the new law. The Act’s repeal of the exemption deduction does not affect these children because their parents claimed the exemption deduction under pre-Act law. However, the increase in the standard deduction from $6,350 in 2017 to $12,000 in 2018 significantly increases the amount of earnings dependent children can receive before being subject to federal income tax. Unless employed by a parent, children remain subject to payroll taxes on wages earned and on net income from self-employment over $400.
Self-employed parents should hire their children. Generally, the children will be in a lower tax rate bracket than the parents, allowing the shifting of income from a higher tax rate bracket to the children’s lower tax rate brackets.
A parent, as the employer, does not need to withhold or pay Social Security or Medicare tax on a child under age 18, or pay federal unemployment tax on the wages of a child under the age of 21. Because of this favorable treatment, wages paid by parents to children are scrutinized closely by the IRS. Be sure the wages paid are directly connected to the parent’s business, reasonable in amount, and for services the parent can prove were provided by the child.
Example: The parent is married, in the 24 percent tax rate bracket, and subject to self-employment tax. If the parent has business filing, typing, or other chores the child can help with, the parent can deduct the child’s wages against the parent’s business income. If the parent paid the 16-year-old child $12,000 in 2018, the approximate savings would be:
Parent’s tax saving from deducting the wages: federal tax ($12,000 x 24 percent) of $2,880, plus self-employment tax ($12,000 x 15.3 percent) of $1,836 for a tax savings of $4,716.
Child’s tax assuming no other income: wages of $12,000, and the standard deduction of $12,000, for taxable income of $0, and federal income and payroll tax of $0, for a total federal tax savings to the family of $4,716.
Additionally, the child is eligible to contribute to an individual retirement account (IRA or Roth). In the above example, if the child contributes $5,500 to a deductible IRA, the child could earn up to $17,500 ($12,000 + $5,500) and still pay no federal tax. Alternatively, earnings up to $5,500 could lead to a Roth IRA contribution.
Effect of the Kiddie Tax on Investment Income
Before 1986, parents shifted investments to children so that interest, dividend, and capital gain income from the investments would be reported on the children’s returns. Often, little or no tax was paid because they sheltered the investment income with their standard deduction and exemption deduction and paid tax at the children’s low tax rates.
In 1986, Congress attacked this tax strategy in two ways. First, if the parents claimed the child as a dependent on their return, the child’s standard deduction decreased to the greater of $1,050 or the child’s compensation income plus $350, up to the single standard deduction amount. This limitation on the child’s standard deduction continues to apply under the new law after 2017. Thus, if the child’s compensation income is $500, the child’s standard deduction is $1,050. If the child’s compensation income is $2,400, the child’s standard deduction is $2,750 ($2,400 + $350), up to a maximum of $12,000 in 2018.
Second, if the child’s unearned (investment) income was more than $2,100, under the so-called Kiddie Tax, the child’s investment income—but not earned income—was taxed at the tax rate of one or both parents. Complicated rules required the use of the higher-income parent’s AGI when the parents were divorced and the aggregation and proration of all the children’s income when more than one child had investment income greater than $2,100.
The Act simplifies this calculation procedure by removing the parents’ and siblings’ incomes from the calculation. Instead, each child’s tax is calculated using the compressed estate and trust tax rates rather than the parents’ tax rates. The trust tax rates for ordinary income and capital gain and dividend income are set out in the table on page 32.
Whether the new approach results in lower tax than under old law depends on the parents’ and child’s incomes. The following example contrasts the treatment of a child’s investment income under old law and new law:
Example: The parents file jointly, reporting taxable income of $300,000. This level of income subjects them to the 33 percent ordinary tax rate and the 15 percent capital gain rate. Their 15-year-old daughter receives $15,000 of investment income from mutual funds given to her by her parents and other relatives. The child’s tax computation is shown in the table on page 32.
The Kiddie Tax expectations under the new law compared to the old law include:
- If the parents’ income under old law was subject to the maximum tax rates (39.6 percent and 20 percent), the child’s tax will be lower under new law.
- If the parents’ income under old law was below the maximum tax rate (39.6 percent and 20 percent) and the child has significantly more than $12,700 of investment income, the child’s tax could be higher under the new law.
- Expect that children will pay less tax on investment income under the new approach, suggesting the use of UGMA accounts and trusts may be beneficial.
Planning strategies under the new law include:
Children with income under $1,050 do not even have to file a tax return, unless he or she has net earnings from self-employment of $400 or more.
A child who is potentially subject to the Kiddie Tax can still receive $2,100 of investment income in addition to compensation income before paying tax at trust rates.
The first $2,600 of capital gains and qualified dividends in excess of the $2,100 is eligible for the zero capital gain rate, making it possible to shift up to $4,700 ($2,100 + $2,600) of income from growth stocks tax-free to each dependent child.
When a child’s investment income reaches $4,700, consider investments that do not increase the child’s taxable income, such as tax-exempt municipal bonds, stocks that pay no dividends, real property that appreciates in value, and tax-deferred U.S. savings bonds.
Split the child’s income with an irrevocable trust, a separate tax entity that would make it possible to accumulate an additional $2,600 of taxable income at a 10 percent ordinary income rate and possibly a zero capital gain rate.
If the purpose of the child’s account is to save money for college, consider using a 529 plan that accumulates investment income tax free.
Including a Child’s Income in the Parent’s Tax Return
If a child is subject to the Kiddie Tax, parents can avoid preparing a tax return for the child, but not the additional tax, by including the child’s income on the parents’ return. As under old law, Form 8814 may be used to accomplish this result if the following requirements are met: (1) the income must be only from interest, dividends, and capital gain distributions; (2) the child’s investment income must be more than $1,050 and less than $10,500; and (3) the child must not file a joint return or pay estimated tax payments.
The downside of using Form 8814 is that the inclusion of the child’s income in the parents’ return increases the parents’ AGI, possibly reducing the parent’s deduction for medical expenses, subjecting them to the 3.8 percent surtax on investment income, or limiting contributions to traditional and/or Roth IRAs.
Should Parents Claim Children as Dependents After 18?
Under old law, battles between parents and the child for the child’s exemption deduction frequently occurred in the child’s early 20s. With the repeal of the exemption deduction and the child credit only being available until a child is 17, the tax value to a parent of claiming a child as a dependent after the age of 18 is significantly diminished.
Parents claiming head-of-household filing status or claiming credits for the payment of college expenses may still benefit from claiming the child as a dependent, but not claiming the child as a dependent allows the child to claim a full standard deduction, avoid the Kiddie Tax, claim the college credit, and possibly qualify for college financial aid. Financial planners can help families analyze the pros and cons to reach the most beneficial outcome. Additional planning may be needed to assure the child is entitled to his or her exemption based on earned income and the amount of support.
Randy Gardner and Julie Welch are co-authors of the recently updated 101 Tax Saving Ideas (11th edition). To obtain a copy, email Julie HERE.