Kiddie tax may be due on college scholarships.

• Author: Chambers, Valrie

The "kiddie tax" rules, under which dependent children's unearned income is taxed at the parents' higher tax rate, have long applied to unearned income in excess of an amount indexed to inflation ($1,050 for 2016). Congress passed this rule as part of the Tax Reform Act of 1986 (TRA), P.L. 99-514, to thwart the shifting of income-producing assets among family members to reduce federal income tax (S. Rep't No. 99-212, 1986; H.R. Rep't No. 99-426, 99th Cong., 1st Sess. (1985)).

However, the TRA defined unearned income to include anything except Sec. 911 earned income, rather than investment income. Earned income is defined in Sec. 911(d)(2)(A) as

wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered, but does not include that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation which represents a distribution of earnings or profits rather than a reasonable allowance as compensation for the personal services actually rendered. Consequently, the taxable portion of college scholarships may be unearned income and subject to the kiddie tax.

In 1986, this was not a material issue because, when it was enacted, the law applied only to children under 14 years of age. Now that the age has been raised to children under 24 for certain full-time college students, the blessing of a scholarship may come with an unanticipated tax shock and requires CPAs to consider this wrinkle in tax planning. Beginning with 2013 returns, the IRS changed the title of Form 8615 from Tax for Certain Children Who Have Investment Income of More Than $1,900 to Tax for Certain Children Who Have Unearned Income. Similarly, the instructions for the form were changed to include taxable scholarship and fellowship grants not reported on Form W-2, Wage and Tax Statement.

To be clear, Sec. 117 allows scholarships for tuition and fees required for attendance and other fees and expenses required for courses to be...