The "kiddie tax" on qualified dividends and net capital gains.

• Author: Pope, Thomas R.

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...