For centuries, individuals have looked for ways to pay little to no income taxes. The methods for avoiding income taxes may be more complex today because the IRS has a better understanding of what these techniques are and how to combat them. However, these tax strategies usually started out simpler.
One common joke about having children has been viewing them as a “tax deduction”. By generating a dependency exemption (pre-Tax Cuts and Jobs Act 2017) and the potential of claiming multiple tax credits including the Child Tax Credit, children can allow individuals to claim certain tax benefits.
A tax loophole that many high-net-worth individuals had discovered was having their children generate income on their behalf and be subject to a lower tax rate. What does this look like? Picture it this way: Individual A who earns large amounts of income and has multiple income streams is generally subject to higher tax rates, stricter tax rules, and more taxes to pay. If Individual A knew another Individual who was not their spouse (call them Individual B) who could generate income and Individual A could dictate what is done with that income, Individual B could file a tax return reporting that specific income, and Individual B would be subject to lower tax rates, less-strict rules and lower taxes due. In the end, Individual A would have the authority over what that income was used for and have to pay less taxes.
Children were the main driver of this loophole but were limited to earning only passive income for a variety of reasons (labor laws, kids are too young to work, etc.). Parents would open investment account for their children, drop the money in and watch the passive income grow shielded from the higher tax rates. Sounds easy enough? The IRS caught onto this popular tactic and would advise Congress to include new laws as a part of the Tax Reform Act of 1986. Thus, the Tax on a Child’s Investment and Other Unearned Income (commonly referred to as Kiddie Tax) was born.
Under Kiddie Tax rules, if a child was reporting over certain thresholds for investment income & unearned income, the child would then be subject to the parent’s tax rates. For 2018 & 2019, the rules were temporarily changed from TCJA where there was an option to use estates/ gift tax rates or the parent’s rates. This was then quickly reverted back through the Consolidated Appropriations Act of 2020 was passed. For more information on kiddie tax, see Form 8615 instructions.
Many children of high-net-worth individuals have investment accounts opened to help them establish a good financial foundation for the future. It is important to understand these rules in order to calculate the correct amount of taxes due for a child’s return in this situation. You cannot assume the tax software will calculate correctly. If you have children with investment income and/or unearned income and want to know more, reach out to your KN+S professional or contact our office for assistance.
IRS Website on Kiddie Tax: https://www.irs.gov/taxtopics/tc553
IRS Form 8615: https://www.irs.gov/forms-pubs/about-form-8615
Eddie Mitchell, CPA, is a Senior Tax Accountant at Katz, Nannis + Solomon, P.C. If you have any questions or would like to speak with one of our tax professionals, please contact our office at 781-453-8700.