Navigating the New “Kiddie Tax” Rules

When Congress passed legislation in May that extended the so-called Alternative Minimum Tax (AMT) patch for one more year, the law included a provision that eliminated the “Kiddie Tax” break for dependent children between the ages of 14 and 18 who have investment income over $1,700. All dependent children under age 18 are now required to be taxed at their parents’ rate on unearned income of $1,700 or more retroactive to January 1, 2006.

Previously, dependent children who were over 14 and under 18 years old could have unearned income of $800 tax free, and pay tax on anything over that at the child’s usually lower rate. Children under age 14 paid at their parents' rate after their incomes exceeded $1,600.

Congress tacked on the provision to the AMT fix as a way of making up for some of the lost revenue. The government estimates that the change will yield $2.1 billion over the next ten years, The MotleyFool.com says.

The biggest problem the change has presented to taxpayers was that since it became effective immediately and was retroactive, there was no way to prepare for the impact on 2006 returns. Parents may have sold stock for a child before May 2006 that earned a large capital gain, with no knowledge of what the tax consequences might be, US News.com says.

Currently dependent children under 18 with unearned income are required to file a separate return if that unearned income exceeds $800. The first $850 of income is tax free and the second $850 is taxed at the child’s rate. If the child has income in excess of $1,700 he or she must file Form 8615 with his tax return.

Form 8615 for 2006 is available on the IRS web site and in Publication 17. The tax preparer must enter the parents’ taxable income and tax owed when calculating the child’s tax liability.

Publication 929, “Tax Rules for Children and Dependents” has not yet been updated for 2006, but the 2005 version says that if the parents’ income is not known by the time the child must file, the child may use estimates of income and tax when filing Form 8615. In the event that the parents file for an extension, the IRS says, the children may also file for extensions.

Parents may elect to include the child’s income with their own by filing a Form 8814, but this election can have a negative impact on the parents’ tax position. It is important to run the numbers to determine which scenario works best for the taxpayer. Publication 929 for 2005 also notes that if parents elected to include their child’s investment income on their own return and do not pay sufficient estimated tax, they will be subject to penalty.

Roy Lewis, writing for the Motley Fool says that many of his clients who were looking for a tax advantaged way to pay for college costs and did not necessarily have high incomes had used this exception and were able to save thousands of dollars. But tax preparer Lawrence Silverman of Weymouth Mass. said that few of his middle-income clients used the tax break, USNew.com reports.

The kiddie tax was originally enacted in 1986 to prevent the transfer of assets from parents to children as a way of avoiding taxes, and according to Silverman the new law reflects the rationale of the original provision. “It’s not really the kid’s money, he says. “It is a way for the parents to avoid tax.”

Taxpayers whose children have investment income should prepare for 2007 by anticipating transactions that can generate a capital gain, changing their children’s investment mix to securities that produce lower income, USNews.com recommends. Parents with children around 14, who had anticipated the tax break, might consider transferring assets into a new 529 plan that is opened in the child’s name, the Washington Post suggests. The money cannot be rolled over to a 529 plan that is in the parent’s names because assets given to a child have to remain in the child’s name.

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