The “Kiddie Tax” on Qualified Dividends and Net Capital Gains

The “kiddie tax” has been in the law since 1987 and has often been a thorn in the side of taxpayers and their advisers. With the 2003 reduction in tax rates for qualified dividends and net capital gains, this tax has become even thornier; tax professionals have to figure out how to apply the law and advise their clients. This is particularly true when there are qualified dividends and/or net capital gains.

Under Sec. 1(g), unearned income (UI) of children under age 14 is taxed partially at their parents’ marginal tax rate and partially at their own tax rate. When such children’s UI includes qualified dividends and net capital gains, the tax computation becomes more complicated, because these sources of UI are taxed more lightly than ordinary income. Further, qualified dividends and net capital gains may be taxed partially at the parents’ preferential tax rate (e.g., 15%) and partially at the child’s preferential tax rate (e.g., 5%). When parents have two or more children under age 14 with UI, applying these rules becomes very complicated and can lead to unusual and illogical results.

Taxation of NUI

Net unearned income (NUI) is the portion of a child’s UI taxed at his or her parents’ marginal rate; in 2005, it is typically UI in excess of $1,600 ($800 standard deduction + $800 statutory amount); see Secs. 1(g)(4)(A)(ii)(I) and 63(c)(5)(A), and Rev. Proc. 2004-71. NUI is smaller if the child’s itemized deductions directly connected to the production of UI exceed $800. Any of the child’s income in excess of NUI (non-NUI) is taxed at his or her rate (thus, the first $800 of UI is not taxed, the next $800 is taxed at the child’s rate and the excess of UI is taxed at the parents’ marginal rate). If the child’s UI consists partially of qualified dividends and net capital gains, a question arises as to the extent to which they are included in NUI. According to the IRS instructions to Form 8615, Tax for Children Under Age 14 With Investment Income of More Than $1,600, and Pub. 929, Tax Rules for Children and Dependents, a pro-rata allocation of $1,600 to qualified dividends, net capital gain and ordinary UI is required, so that a portion of each type of UI is partially NUI and partially non-NUI.

Example 1—one child: X is a dependent child, under age 14, whose only income is $9,000 taxable interest and $6,000 qualified dividends ($15,000 total UI). X’s parents have $250,000 taxable income (in the 33% tax bracket) and no other children. X’s taxable income is $14,200 ($15,000 – $800 standard deduction) and $13,400 NUI ($15,000 – $1,600). X’s $1,600 non-NUI must be allocated between the taxable interest and qualified dividends as follows: $960 to interest ($1,600 ($9,000/$15,000)) and $640 to dividends ($1,600 ($6,000/$15,000)). Thus, X’s UI consists of the following amounts:

The $8,040 NUI interest income is taxed at X’s parents’ 33% ordinary rate; the $5,360 NUI qualified dividends are taxed at their 15% preferential rate. Thus, the tax on X’s NUI is $3,457 (($8,040 0.33) + ($5,360 0.15)), which Sec. 1(g)(3) refers to as the “allocable parental tax.” Of the remaining $800 of X’s taxable income ($14,200 – $13,400), $640 is deemed to be dividends and is taxed at 5%, while the other $160 ($800 – $640) is ordinary income and is taxed at 10%. X’s total tax is $3,505 ($3,457 + ($640 0.05) + ($160 0.10)); see the exhibit for a summary of the computations.

Multiple Children

If a child has siblings who are also under age 14, the $1,600 is allocated separately for each child. However, all of the NUIs are aggregated and added to the parents’ taxable income, and a tax is computed on the aggregate. The parents’ original tax liability is then subtracted from this hypothetical tax. The result is an aggregate tax for all of the children, which is then allocated to each child based on his or her relative NUI. The composition of each child’s NUI is irrelevant in allocating the aggregate tax. Children whose NUI, relative to their siblings, has a higher proportion of qualified dividends and net capital gain, end up sharing some of the tax benefits on this income with their siblings, and also bear some of the heavier taxes on the ordinary portion of their siblings’ NUIs.

Example 2—two children: A and B are two siblings, both under age 14. A has $10,000 taxable interest; B has $10,000 of qualified dividends. Their parents have $250,000 taxable income (in the 33% tax bracket). Each child has $9,200 taxable income ($10,000 – $800 standard deduction) and $8,400 of NUI ($10,000 – $1,600). A’s NUI will be taxed at the parents’ 33% ordinary rate; B’s NUI is taxed at their 15% preferential rate. The tax on the children’s aggregate NUI (the allocable parental tax) is $4,032 (($8,400 0.33) + ($8,400 0.15)). Each child is allocated $2,016 of this tax ($4,032 ($8,400/$16,800)). Each child has $800 of non-NUI taxable income ($9,200 – $8,400). A’s is taxed at 10% (interest), while B’s is taxed at 5% (dividends). A’s total tax is $2,096 ($2,016 + ($800 0.10)); B’s is $2,056 ($2,016 + ($800 0.05)); see the exhibit for a summary of the computations.

Note that A’s and B’s taxes differ very little, even though A’s UI consists entirely of taxable interest, while B’s is wholly qualified dividends. Because the tax on their aggregate NUI is allocated without regard to its composition, each child’s NUI is effectively taxed at a 24% rate ($2,016/$8,400), with A reaping some of the benefits of the preferential tax rate on B’s qualified dividends. This does not seem to be an appropriate outcome. However, any concern about it should be reduced, because it is all occurring in the same family.

Conclusion

The imposition of the kiddie tax when there is one child is fairly straightforward, although it becomes more complicated if the child has qualified dividends or net capital gain. However, when there are two or more children subject to the kiddie tax, the tax allocation may generate unusual and illogical results when the children’s income consists partially of qualified dividends or net capital gain and the composition of each child’s portfolio is different. Tax advisers are left with a tax law that frustrates planning for children of the same family.

From Thomas R. Pope, CPA, DBA, Associate Professor, and David S. Hulse, Ph.D., Associate Professor, University of Kentucky, Lexington, KY (Not Affiliated With PKF North American Network)