The kiddie tax: inequitable consequences and the need for reform.

• Author: Chanel, Gerri B.

EXECUTIVE SUMMARY

* The kiddie tax was added by the 1986 Tax Reform Act to prevent parents in higher tax brackets from avoiding tax on income from investment assets by transferring them to their children.

* Under the kiddie tax rules, a child over a specified age (originally 14) at the end of a tax year must pay tax on unearned income over a specified amount at the higher of the child's marginal tax rate or his or her parent's marginal tax rate.

* In 2006 and 2007, the law was amended so that the kiddie tax now applies to dependents up to age 18 and up to age 23 if they are full-time students. The income threshold for the tax is $2,100 for 2015.

* From the beginning, the kiddie tax rules have been criticized because they cause complexity for taxpayers, create economic distortions and savings disincentives, and fail to effectively prevent income shifting.

The "kiddie tax" was enacted in 1986 as what was intended to be a simple-enough mechanism to prevent a small number of wealthy parents from shifting income-producing assets to young children who were in lower tax brackets. Application of the tax quickly led to what some have called unintended consequences, though, in fact, they were not: The law's crafters clearly were aware of possible inequitable outcomes.

Over the years, as the age limit for the tax has increased from 14 to 18 and up to 23 for full-time students, so too have the problems of inequity. The repeated raising of the age limit has also led to problems of complexity and confidentiality that were unlikely to have occurred with a 14-year-old. This article addresses the problems caused by the increases in the age at which the kiddie tax applies and explains why, as the kiddie tax heads toward its 30th birthday, it is time for Congress to reform it.

From Kiddie Tax to Student Tax

The kiddie tax was added by the Tax Reform Act of 1986 (TRA), (1) the goal of which was to simplify the tax system and reduce tax rates overall, while broadening the tax base by eliminating tax shelters and other loopholes. Among its many other provisions, the TRA modified the taxation of children by eliminating the personal exemption for taxpayers who could be claimed as dependents on another's return and by limiting the standard deduction of these taxpayers to the greater of $500 ($1,050 for 2015) or $250 ($350 for 2015) plus the taxpayers' earned income. (2)

The TRA also introduced the "kiddie tax" to target wealthy parents who were shifting income-producing assets to their children, who were usually subject to lower tax rates. The new Sec. 1(i) (later changed to Sec. 1(g)), applied to tax years beginning after Dec. 31, 1986, and provided that, for any child who was under age 14 at the end of the tax year, any unearned income of the child over $1,000 would be taxed at the higher of the child's marginal tax rate or the parent s.

By the end of 2005, the exemption from the kiddie tax had risen from $1,000 to $1,600, (3) and other minor changes to the tax had been made. In May 2006, a major change occurred as Congress passed the Tax Increase Prevention and Reconciliation Act, (4) raising the application of the kiddie tax from under age 14 to under age 18, effective for 2006. Just a year later, the Small Business Work Opportunity and Tax Act of 2007 (5) raised the age to under 19, or under 24 for full-time students. It is likely that both changes were simply to raise revenue, since the committee reports for both pieces of legislation give no reason for the change.

The choice of age 14 in the 1986 legislation was not arbitrary; it was based on specific reasons described below. However, the original legislative intent was lost with the subsequent increases in age. According to a 2010 report by the President's Economic Recovery Advisory Board, (6) about half of kiddie tax filers at that time were college students, and about 40% were between age 14 and 18, meaning that only 10% of the filers were those envisioned by the original legislation.

Complexity

The kiddie tax legislation of 1986 was originally proposed early in the legislative...