By Sam Brunson
One of the first articles I published as an academic was on the kiddie tax. It was a sleepy corner of the tax world; most of the academic literature on the kiddie tax came from the 1980s.[fn1] And, for its first three decades, the kiddie tax stayed almost exactly the same.[fn2] Then, in a little-noticed provision of the TCJA, Congress fundamentally changed the kiddie tax. In response, I addressed the kiddie tax a second time in a piece for Tax Notes entitled Meet the New “Kiddie Tax”: Simpler and Less Effective. [Paywall] It turns out that I underestimated the ways in which is was not only less effective, but actually dangerously counterproductive.
But first, a quick primer into what the kiddie tax was and what it has become. In 1986, Congress had become worried that wealthy taxpayers were shifting income-producing assets to their children so that they could lower their tax bills. The tax game would go something like this: wealthy dentist father gives (or, I suppose, sells for a nominal amount) his x-ray machines to his 7-year-old daughter. He then leases back the x-ray machines for, let’s say, $10,000 a year. In 1985, the top marginal tax rate was 50%. Assuming our dentist was in that tax bracket, he could deduct the $10,000 he paid to lease the x-ray machines. Meanwhile, assuming that his 7-year-old daughter didn’t have any additional income, she would have been in the 16% tax bracket. According to Rev. Proc. 84-79 (and ignoring any exemptions or deductions she might have), the daughter would pay taxes of $1,054 on the $10,000 of income. Meanwhile, Dad’s $10,000 deduction saved him $5,000 in taxes. By shifting passive income to his daughter, then, Dad saved almost $4,000.[fn3] (Note that it didn’t have to be dental equipment: it could be any income-producing property).
How did the kiddie tax prevent this income-shifting? The concept was fairly simple: children would pay taxes on their unearned income at their parents’ marginal tax rate. Magically, that should eliminate the incentive to transfer income-producing property, at least if the transfer is meant solely to reduce the parents’ tax bill, because that reduction on longer happened. As an anti-abuse rule, the kiddie tax was overinclusive—it captured income shifting, true, but it also captured kids who earned money, invested that money, and got a strong return on their investment. That wasn’t the end of the world, though, because a child’s marginal tax rate would, at the very least, never exceed her parents’ tax rate.
While conceptually easy, the kiddie tax was complicated to calculate. The TCJA purported to fix that problem. Instead of calculating a child’s taxes at her marginal rate, then recalculating them by separating her earned income from her unearned income, and calculating her taxes on her earned income at her rates and her unearned income at her parents’ rate, than determining which was higher and paying taxes at that rate, the TCJA divorced the kiddie tax from a child’s parents’ tax rate. Instead, children pay taxes on their unearned income using the marginal rates applicable to trusts and estates.
Those rates, it turns out, are wildly compressed. Where, in 2019, a married couple filing a joint return has to earn $612,350 dollars before they pay the top marginal rate of 37%, trusts and estates pay at 37% when their income reaches $12,750.
Is that bad? Yes, it turns out. The Wall Street Journal recently reported that the children of active duty service members killed in the line of duty (often called Gold Star families) receive a survivor’s benefit. And that survivor’s benefit is being taxed to children at the top marginal rate, even where the children’s surviving parent earns a fraction of the $612,350 that would put that parent in the top marginal bracket. A week later, the New York Times reported that low-income college students are facing top marginal tax rates on scholarships they receive.
Could that be true? Absolutely. The Code defines “unearned income” as basically any type of income other than for services performed. Death benefits are clearly going to qualify as taxable income, but it’s not income for services that the surviving child performed.
And how about scholarships? Well, “qualified scholarships” don’t constitute income. But a qualified scholarship must be used for tuition, fees, books, supplies, and equipment. So if a student gets a scholarship that also pays for housing, that part of the scholarship is taxable income. And not only is it taxable income, but it’s unearned income, subject to higher rates.
Under the pre-TCJA kiddie tax, this wouldn’t be a big deal. If the survivor’s surviving parent earned less than $52,000, the child may have seen her tax rate rise to 12%, but that’s significantly lower than 37%. And if the poor college student’s parents were in the lowest tax bracket, the kiddie tax wouldn’t affect her (because children paid at the higher of their own rate or their parents’ rate).
Now that the kiddie tax is untethered from parents’ marginal rates, though, the ceiling has gone away.
So will Congress fix the problem? I’ll go into that in Part 2. (Spoiler: maybe, kind of.)
[fn1] It was kind of an evergreen topic in the more practitioner-oriented journals, but those understandably focused less on the policy questions and more on the practical ones.
[fn2] There were a couple changes. For instance, the age at which one qualified as a “kiddie” rose from 14 to, in some circumstances, 24. But there were no major conceptual changes.
[fn3] There are a couple of assumptions here, like that Dad could control daughter’s assets. Which, when daughter is younger than 14, is almost certainly true.