One of the items getting little attention in the recent round of tax reform is the kiddie tax.  Passed by Congress in 1986 to prevent taxpayers from shifting income to their kids (presumably in a lower bracket) the tax raises more than $1 billion per year for Treasury.

What is it?

The kiddie tax is a special levy on a child’s unearned income about $2,100.  Unearned income is typically portfolio income (e.g. interest, dividends and capital gains).  Earned income (i.e. income from a job) is not subject to the kiddie tax.

Who is impacted?

Originally the kiddie tax applied to children under the age of 14.  Over time it has been expanded by Congress and, today, applies to nearly all children under the age of 18 plus many who are under the age of 24 if they are full-time students who rely upon the Bank of Mom and Dad for financial support.

So, what’s the change?

Under prior law unearned income was taxed at the parents’ rate.  Under the new law (which will continue through 2025 unless changed by Congress) it’s taxed at rates typically reserved for trusts.

Is it a big deal?

Maybe.  For interest and dividends it’s less clear.  For capital gains it’s a huge deal.  Under the old rules the threshold for the top capital gains rate of 20% was more than $400,000.  Under the new rules the 20% rate kicks in at $12,700.

Who loses?

Children of parents in lower brackets.  Here’s an example:

Johnny Student attends State U on a full-time basis.  Johnny’s parents have taxable income of about $150,000.  To aid in making tuition payments his grandparents gift to him stock with embedded long-term capital gain of $40,000.

Under the old rules Johnny’s kiddie tax would have been about $5,700 given the 15% capital gains rate faced by his parents.  Under the new rules his tax bill increases about $900 to about $6,600 because a portion of the gain is assessed at the top capital gains rate of 20%.

Is there a workaround?

There’s always a workaround!  Grandmother and Grandfather can gift stock to Mom and Dad who in turn can sell the stock and pay LT capital gain at 15%.