Kiddie Tax Revisited

Doug H. Moy
January 9, 2008 — 1,769 views  
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My oh my. . . . Congress never ceases to amaze me in its game of semantics when it comes to matters of taxes; to wit, Tax Increase Prevention and Reconciliation Act of 2005 (“TIPRA ’05”) [(H.R. 4297; H. Rept. 109-455, 5/9/06); Pub. L. No. 109-222, 109th Cong., 2d Sess. (17 May 2006)], signed by President Bush on May 17, 2006. Of striking interest are the words, Tax Increase Prevention. . . . Tax Increase Prevention for whom? Certainly not for those persons intent on establishing trusts to provide education funds or investment opportunities for children under the age of eighteen years. Prior to TIPRA ’05, the net unearned income of a child who had not attained age fourteen before the close of the taxable year and whose parent was alive at the close of the taxable year was taxed to the child but at the parent’s highest marginal tax rate [IRC § 1(g)(2); (g)(1)(B)]. Under TIPRA ’05, age eighteen is substituted for age fourteen [IRC § 1(g)(2)(A); § 510(a) TIPRA ’05 amending IRC § 1(g)(2)(A)]. This provision applies regardless of the source of the assets creating the child’s unearned income [Conf. Rept. p. II-767 TRA’86]. The Kiddie Tax does not apply to a child under the age of eighteen years who is married and files a joint return with his or her spouse for the taxable year. In the case of any child who is a beneficiary of a qualified disability trust [as defined in IRC Section 642(b)(2)(C)(ii) and defined by cross-reference to Sections 1917 and 1614(a)(3) of the Social Security Act], any amount included in the income of such child under IRC Sections 652 and 662 during a taxable year is considered earned income of the child for the taxable year and is exempt from the kiddie tax [IRC § 1(g)(4)(C), added by § 510(b) TIPRA ’05]. Apparently, this tightens a loophole used to shelter investment income. The amended kiddie tax provision applies to taxable years beginning after December 31, 2005 [§ 510(d) TIPRA’05]. These changes to the kiddie tax are expected to raise $776 million over five years and $2.128 billion over ten years [Senate Finance Committee, Summary of the Tax Increase Prevention and Reconciliation Act of 2005, page 8 of 10, May 9, 2006]. As amended by the Small Business Work Opportunity Act of 2007 [Pub. L. No. 110-28, 110th Cong., 1st Sess. (25 May 2007), Section 8241(a) of Subtitle B of Title VIII], age eighteen is extended to age nineteen, if such individual has not attained the age of nineteen as of the calendar year in which the taxable year of the taxpayer (i.e., the individual for whom the kiddie tax applies) begins, or is a student who has not attained the age of twenty-four as of the close of such calendar year [IRC §§ 1(g)(2)(A)(I) and (ii); 152(c)(3)(A)(i) and (ii)]. These changes apply to tax years beginning after May 25, 2007. Certainly, this is yet further evidence of how reducing the individual income tax rates has, in effect, caused more income tax to be raised by broadening the income tax base to young adults up to the age of twenty-four to be taxed at their parents’ highest marginal income tax rate bracket. Moreover, indirectly, this is further evidence of Congress’ objective to discourage the use of trusts to accumulate income for younger beneficiaries. Such an objective, whether openly spoken or written, further confounds trustees in their investment choices for trust estate property for certain beneficiaries under the age of twenty-four. But wait. . .what about the Tax Increase Prevention part of the Reconciliation Act of 2005? Investment planning for trustees of trusts established for beneficiaries older than fourteen years but younger than twenty-four years will now take on new meaning. Now is the time to review with trustees their investment strategies. If unearned income of the trust is accumulated—that is, not distributed currently—such income may be subject to the compressed income tax rates for trusts. Is this not a tax increase? For example, in tax year 2007, all income accumulated in the trust in excess of $10,450 is subject to income tax in the amount of $2,701, plus 35 percent of the excess over $10,450 [IRC § 1(e); Rev. Proc. 2006-53, 2006-48 I.R.B. 996]. In tax year 2008, all income accumulated in the trust in excess of $10,700 will be subject to income tax in the amount of $2,764, plus 35 percent of the excess over $10,700 [IRC § 1(e); Rev. Proc. 2007-66, 2007-45 I.R.B. 1]. A complex trust is permitted only a $100 income tax exemption compared with an $900 unearned income exemption permitted the child under age eighteen, if the unearned income were currently distributed to the minor child [Rev. Proc. 2007-66, 2007-45 I.R.B. 1 § 3.02]. A trust that accumulates income, may or may not distribute income in the trustee’s discretion, distributes principal or makes charitable contributions is a complex trust [IRC § 661(a); Treas. Reg. § 1.661(a)-1 (n.d.)]. Apparently, though, the voodoo accounting used by Congress to raise an expected $776 million over five years and $2.128 billion over ten years by increasing the kiddie tax age from fourteen years to eighteen years is not viewed as a “... Tax Increase...!” My oh my, how interesting the semantics used to mask a “tax increase” with tax legislation that is supposed to be “Tax Increase Prevention....” Copyright © 2007, 2008 by Doug H. Moy. All rights reserved.

Doug H. Moy

Doug H. Moy is a nationally recognized author, consulting specialist, seminar instructor and educator. He has an undergraduate degree from Willamette University and a Masters degree from Washington State University. Since 1979, Mr. Moy has consulted to attorneys, tax practitioners and their clients, as well as assisted practitioners representing clients before the IRS Conference of Right and Appeals Division and Settlement Conference Negotiations. He is noted for his ability to communicate his unparalleled knowledge and experience to practitioners at all levels in his field of expertise; namely, estate/gift taxation and planning, with special expertise in living trusts; community property; lottery prize winnings; structured settlement trusts; extricating clients from abusive trust tax shelters; designing effective estate plans; and preparation of Form 706 Estate Tax Returns and 709 Gift Tax Returns. He offers particular assistance and exceptional skill designing creative, practical solutions to challenging and difficult estate planning situations.