Written by: Thomas M. Geier, CPA, CFP®, PFS
Back in 1986, Congress wanted to reform and simplify the tax code and passed the Tax Reform Act of 1986. The new act accomplished many positive goals for making income taxes less onerous, reducing rates, and eliminating tax loopholes. One shelter that Congress wanted to clear up was the ability of wealthy parents to shift income into their children’s names and avoid paying the tax rate of the parent. This tax avoidance scheme was not very prevalent, but was, nevertheless, unwanted. Congress put language in the new Tax Reform Act that forbid such income shifting, which soon became known as the “Kiddie Tax.”
The logic was simple enough. If a child had earned income over a certain level, tax must be paid at the higher of the child’s bracket or the parent’s bracket. Therefore, there was no incentive to put income producing assets in a child’s name in order to pay a lower rate. However, the unintended consequence was that now, children who worked and saved on their own, would be forced to pay tax rates as high as their parents on the income from their own savings.
The original age limit for application of the Kiddie Tax was age 14. This was not that much of a problem in 1986 as most children under the age of 14 did not work. The Fair Labor Standards Act puts severe restrictions on child labor, defined as a child under the age of 14. So, the new Tax Reform law worked much as intended. However, the law was amended in 2006 to increase the age limit to 18, and even 23 if the child is a full-time student. This now put a whole segment of a working age population under the Kiddie Tax provisions.
One obvious example of complications because of the new age limits is saving for college. Many teenagers work for the purpose of saving for college. As they accumulate savings, the income on these savings becomes taxable at the parents rate at certain thresholds. No one had intended to penalize hard working teenagers. Questions also arose over what constituted unearned income. How were scholarships, grants, tuition plans and other savings vehicles to be treated? How about gifts from non-parental source, such as grandparents? Even Social Security benefits paid to children could be pulled under the Kiddie Tax provisions.
Time for Another Overhaul
There is a growing recognition that the current income tax code is due for another overhaul. In fact, quite a few proposals have been put forth in recent legislative sessions. The goal, again, is to make the tax system fairer and simpler to understand and apply. Hopefully, any legislative changes to the income tax code will address the inequitable outcome of the “Kiddie Tax.”
© Geier Asset Management, Inc. February 2015. Thomas M. Geier is a Vice President of Geier Asset Management, Inc., a Registered Investment Advisor. The above blog reflects the opinions of Mr. Geier and not necessarily the firm. Any advice given is general in nature and investors must consider their own individual circumstances. Past performance is no indicator of future performance.