By Carol A. Magyar, CPA, MST
Tax Director

In the face of public pressure, Congress late last year repealed the provisions in the Tax Cuts and Jobs Act (TCJA) of 2017 that related to what is popularly known as the “kiddie tax.” As a result, provisions governing the kiddie tax will revert to pre-TCJA rules for the 2020 tax year, and affected taxpayers have the choice of using either TCJA rules or pre-TCJA provisions for the 2018 and 2019 tax years. Amended returns for those years may be filed by taxpayers who determine they would benefit from using pre-TCJA rules.

What is the ‘kiddie tax’?

The kiddie tax originated in 1986 and taxed the unearned income of children under age 18 (or up to 23 for fulltime students) at the marginal tax rates paid by their parents. The tax was created, in part, to address the fact that some high-income parents shifted unearned income to their children’s bank accounts to avoid taxation. But the tax also applies to unearned income that children receive on their own, such as interest, dividends, rents, and royalties, as well as taxable Social Security benefits and taxable scholarships.

The TCJA uncoupled the kiddie tax from parents’ marginal tax rates and instead tied it to estate and trust tax rates. This had the effect of accelerating higher taxes on children’s unearned income because of the structure of estate and trust tax rates under the TCJA.

Moreover, tying the kiddie tax to estate and trust tax rates created highly publicized political problems for Congress because it negatively impacted children of Gold Star families – those who had lost a parent in the line of military duty.

The Gold Star family issue

Gold Star spouses qualify for survivor benefits from both the Department of Defense (DOD) and the Department of Veterans Affairs (VA). But 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 transferred DOD benefits to surviving children in order to collect all the benefits paid by the VA. The DOD benefits were considered 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 pre-TCJA tax on these benefits that was imposed at the marginal tax rate of the Gold Star spouse.

While the impacts of the TCJA kiddie tax on Gold Star families were widely publicized, other affected groups of 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.

Some rules remain the same

Whether taxpayers determine that the pre-TCJA rules or the TCJA rules are beneficial to them for the 2018 and 2019 tax years, some rules are consistent for 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 under age 18 or a fulltime student up to age 23 and have earned income for the tax year equal to or less than one-half of their support. If the kiddie tax applies, a separate tax return must be filed for the child.
Earned income includes amounts received as compensation from a job 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 non-property income like taxable Social Security benefits and taxable scholarships not reported on Form W-2.
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.

If you have questions about the kiddie tax, please contact your G.T. Reilly tax advisor.