Tony Nitti for Forbes writes: As the father of two kids under the age of four, I can confidently say that there is no greater lie regarding the recipe for a healthy, happy family than the supposed sanctity of the dinner table.
The boy is the biggest problem. He’s nearly five, he’s growing faster than the national debt, and yet he consumes in the neighborhood of 300 calories per day. Dinner isn’t a meal, it’s a bargaining chip. He spends the entire time staring at his plate, refusing to eat, while explaining why he suddenly has a newfound distaste for whatever it is we’ve made. Then, when the wife and I start clearing the plates and wrapping up our meal, he realizes that he might miss out on desert, and starts offering last-ditch negotiations, which generally involve offering to trade varying quantities of bites of his dinner for members of the chocotastic group. I’ve got to hand it to the kid, though; he’s got me figured out. By the time we get to this point, I’m so exhausted from the process and eager to get him bathed and into bed, I’d gladly trade two bites of chicken for an entire Fudgie the Whale.
My one-year old daughter is no picnic either, but for the opposite reason. She never stops eating. And during dinner, if we don’t keep a constant stream of food available for her to cram into her maw, she starts screaming like she’s been hit with a taser. We’ve reached the point where my wife has to keep an emergency ham on deck at all times so we can get through dinner without a major blowup.
And that’s my dinner. Every. Freaking. Night. Me and my boy working through trade scenarios like we’re Brian Cashman and Billy Beane, interrupted only by my daughter’s screams when we don’t run an IV of 8,000 calories directly into her gullet. And so while the experts will tell you dinner time should be a bonding experience that leaves a father feeling a renewed connection to his wife and kids, the reality is I tend to spend the entire time daydreaming about fleeing to Alaska with the dog and starting over.
Kid’s aren’t all bad, of course. They do offer some nice tax benefits such as dependency exemptions and child tax credits. And because kids are generally shiftless layabouts, they don’t work, meaning they have a nice, untapped lower tax bracket that parents can shift some income to and take advantage of a lower tax rate.
There’s a problem, however, when you shift more than $2,000 of investment income to a kid that is under 18 – or a full-time student aged 19-23 – and he or she has no earned income.
In this situation, the so-called “kiddie tax” of Section 1(g) applies. The kiddie tax is designed to prevent a parent with a high marginal tax rate from shifting investment income to a child in a lower tax bracket by forcing the child to pay tax on the investment income at the parents’ highest marginal tax rate. It works like this:
For 2012, Mr. and Mrs. Smith are in the 35% federal income tax bracket. That is, they would pay $35 in additional tax on every $100 of additional income. They are the parents of a 12-year-old son, Tommy, to whom they transfer a $200,000 bond that pays 10%. Tommy therefore receives $20,000 of investment income. He has no other income.
Had the parents kept the bond, they would have paid $7,000 in tax on the interest ($20,000 × 35%). Tommy, instead, is taxed on $19,000 of taxable income—$20,000 of gross income reduced by his $1,000 standard deduction—as follows. His “net unearned income” is $18,000 (the excess of his interest income above $2,000). This part of his taxable income is taxed at 35%, for a tax of $6,300 ($18,000 × 35%). The rest of Tommy’s taxable income, $1,000 ($19,000 − $18,000) is taxed at Tommy’s 10% tax rate, generating $100 in tax. As a result, Tommy pays a total tax of $6,400, which is still less than the $7,000 his parents would have paid.
Parents who aren’t concerned about the incremental tax savings remaining even after application of the kiddie tax are often faced with a cost benefit analysis: Is it worth paying to have someone prepare tax returns for my children if they’re just going to pay tax at my rates?
If the parents decide it’s not, they are permitted by Section 1(g)(7)(A) to elect to include the income of a child that would be subject to the kiddie tax on the parents’ tax return. If the election is made, the child is treated as having no gross income and isn’t required to file a return.
In the immediately preceding example, Mr. and Mrs. Smith could have elected to simply report the $20,000 of interest income on their joint return and paid the $7,000 tax. If they had done so, Tommy would not have been required to file a return.
Beginning in 2013, however, parents who have shifted income to children but have elected to include the income on their returns – rather than their child’s – may want to rethink the election. Why?
Because beginning in 2013, there is an additional 3.8% surtax that is applied to the “net investment income” of certain taxpayers. The tax applies on thelesser of two numbers:
- The taxpayer’s net investment income, which generally includes interest, dividends, rent, royalties, income from a passive activity, and gains from the sale of certain property, and
- The excess of the taxpayer’s modified adjusted gross income over an applicable threshold: $250,000 if married filing jointly, $200,000 if single or head of household, and $125,000 for married filing separately.
Importantly, this extra 3.8% tax is assessed by chapter 2A of the Code. What we think of as “regular tax rates” – ranging from 10% to 39.6% in 2013 – are provided by chapter 1.
If a parent elects to include the investment income of a child on his return, rather than the child’s, they will be increasing both their net investment income as well as their adjusted gross income. Because these are the two components of the “lesser of” test, it becomes likely that the income the parents elect to report on their return will not only be subject to their marginal tax rate, but the 3.8% surtax as well.
For 2013, Mr. and Mrs. Smith are in the 39.6% federal income tax bracket. On their own, they have net investment income of $100,000 and adjusted gross income of $500,000. They are the parents of a 12-year-old son, Tommy, to whom they transfer a $200,000 bond that pays 10%. Tommy therefore receives $20,000 of investment income. He has no other income.
Had the parents elected to report Tommy’s $20,000 of interest income on their return, they will pay $7,920 in chapter 1 income tax ($20,000 *39.6%). Mr. and Mrs. Smith will also pay an additional $760 ($20,000 * 3.8%) because they are subject to the net investment income tax. The $20,000 of interest income is included in their net investment income, and because their AGI exceeds the applicable $250,000 threshold, the additional tax is due.
If, however, Mr. and Mrs. Smith permit Tommy to file his own return and pay the tax on the $20,000 of interest income, Tommy will not be subject to the additional 3.8% tax on the investment income. This is because the kiddie tax only pulls over the parents’ tax under chapter 1. It does not pull over the 3.8% tax, which is imposed under chapter 2A. As a result, Tommy will be permitted to determine his liability for the net investment income tax by using his own net investment income and his own $200,000 applicable threshold as a single filer.
Instead, Mr. and Mrs. Smith allow Tommy to file his own return and report the $20,000 of interest income. While Tommy will pay tax on $18,000 of the income at his parents’ highest marginal rate of 39.6%, because Tommy’s AGI of $20,000 does not exceed his applicable threshold of $200,000, his is not subject to the additional 3.8% surtax. As a result, Mr. and Mrs. Smith have saved $760 by not electing to report Tommy’s income on their return.
As you can see, parents who are subject to the net investment income tax could shift up to $200,000 of investment income to a child – assuming the child has no other income – and save 3.8% or $7,600, before considering the small incremental savings generated by virtue of the child’s $2,000 floor before being subject to the kiddie tax.
Almost makes those dinners worth it. Almost.
