Tax rules on income of children

Barry Dolowich for the Monterey Herald writes: Q: Our children, ages 10, 12 and 15, just inherited a substantial amount of money from their grandfather. They will be receiving investment income through their respective trusts. What are the tax consequences of this investment income?

A: A number of years ago, Congress limited the tax benefits of using intra-family transfers of income-producing property to children under the age of 14, known as the "kiddie tax." In the past, it was common for parents (and grandparents) in high tax brackets to transfer stocks and bonds to their children (grandchildren) so that the income from these investments would either avoid tax altogether, or be taxed at lower marginal tax rates.

To prevent abuse or tax avoidance, Congress provided that children under 14 with net unearned income (interest, dividends, capital gains, etc.), after certain adjustments, are subject to tax at the top marginal tax rate of their parents. A few years ago, Congress threw up another roadblock in the Tax Increase Prevention and Reconciliation Act, Congress raised the age at which the unearned income of minor children is taxed at the parent's rate from under age 14 to under age 18.

The 2007 Small Business Act contained changes impacting college-aged children. For a child subject to these rules, the child's unearned income over $1,900 will be taxed at the parent's rate, which is presumably higher. For children under age 18, nothing has changed. However, the new law expands the kiddie tax to apply to children who turn 18 during the tax year, or turn age 19 to 23 if the child is a full-time student. These older children are exempt from the new kiddie tax rules if their earned income exceeds one-half of their total support for the year.

Basically, the first $1,000 of each child's 2013 unearned income is not taxable because it is offset by their allowed personal exemption. The next $1,000 of unearned income is taxable at the lowest marginal tax rate of 10 percent. The unearned income in excess of $2,000 is taxable at the parents' highest marginal tax rate. These special rules apply to children who have not reached age 18 before Dec. 31 (or ages 19 to 23 if the child is a full-time student) and do not apply to the child's earned income. The law specifies, however, that the kiddie tax does not apply to a child who is married and files a joint return for the tax year. It also adds an exception to the kiddie tax for distributions from certain qualified disability trusts.

The parent of a child under the age of 18 (or 19 to 23 if the child is a full-time student) may elect to include the gross income of the child in excess of $2,000 (but less than $10,000) in his or her income for the 2013 tax year using Form 8814 provided that such income consists of interest and dividends. If the parents elect not to report the child's income on their return or do not qualify to use Form 8814, then the child must file his or her own tax return and attach Form 8615 to calculate the tax due.

Depending on the amount of taxable investment income earned by your children, they may have to file their own 2013 income tax returns (or you may have to file Form 8814) and pay tax at your (assumed) higher marginal tax rate. You may want to consider the economics of having their windfall invested in tax-free instruments rather than taxable investments.