Congress, Taxpayers Grapple with ‘Kiddie Tax’ Complications

Published June 22, 2019

Federal tax reform lowered the bill for most Americans but had unforeseen effects on the so-called kiddie tax levied on the unearned income of dependents.

Before the 2017 Tax Cuts and Jobs Act (TCJA), the tax on dependent children’s unearned income was quite complicated, Kathleen Pender stated in her business column in the San Francisco Chronicle on May 25.

Many dependents with passive income—from investments on their behalf by parents, for example—had to calculate their taxes two different ways to determine their liability, and dependents’ unearned income was taxed at the parents’ income tax rate. Calculations under the old law were even more complicated if the parents filed separately and if there were siblings involved.

Ended Income-Shifting

Congress created the kiddie tax in the 1980s to stop the practice of wealthy parents  shifting investments to their children to lower their taxes, because the children paid at a lower tax rate.

The tax was applied to minors’ and most full-time college students’ nonwage income, such as interest, dividends, and capital gains.

The TCJA simplified the dependent-tax calculation by taxing the child’s unearned income using the estate and trust tax rate schedules and removing the requirement to consider other family members’ tax situations. In addition, the new law more clearly outlines what can be taxed.

Taxable Income Includes Benefits

The TCJA also includes some of the government benefits children receive in their taxable nonwage income. For example, the retirement benefits received by children as survivors of deceased service members were included, says Tyler Parks, a policy and outreach associate at the Tax Foundation.

“Now the kiddie tax rate is determined by the benefits a child receives rather than the parent’s taxable income,” Parks said.

As a result, the TCJA raised the federal tax liability of some low- and middle-income families whose children received unearned income, says Parks.

“It’s possible that families, especially families with parents paying lower marginal tax rates and children receiving benefits that exceed $12,751, are paying higher taxes on the child’s unearned income after the change,” Parks said.

Uneven Results

When the criteria for taxable dollars changed, it affected the tax rates of some children more than others, says Adam Michel, senior policy analyst at The Heritage Foundation.

“In some cases, kids with unearned income reached the top marginal rates much more quickly than they did under the old system,” Michel said. “This has the effect of increasing taxes on certain taxpayers.”

Policymakers included this provision to keep the cost of the TCJA within the guidelines for the special process that Congress used to pass the legislation, says Parks.

“It is important to note that the TCJA reduced the overall tax liability for 80 percent of Americans,” Parks said. “However, the kiddie tax change raised a portion of taxes for some taxpayers.”

Although the TCJA lowered taxes overall, changes to the tax system create winners and losers, says Michel.

“In the context of the larger TCJA reform, I’m not sure the government wins or loses at the expense of taxpayers broadly,” Michel said. “There are undoubtedly certain individual taxpayers whose tax liability increased.”

The retirement reform bill passed by the U.S. House of Representatives on May 23 would repeal the TCJA provisions and return to the prior, more complicated kiddie tax. The bill is still under consideration in the Senate.

Owen Macaulay ([email protected]) writes from Hillsdale, Michigan.