Kiddie Tax and Taxable Scholarships

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1 Kiddie Tax and Taxable Scholarships Background Information Taxable Scholarship Income (PUB 4012, Page J-1 and Chart B, Page A-2) See PUB 970, Tax Benefits for Education, for additional information including allowed methods to convert a scholarship or fellowship grant (scholarship) into taxable scholarship for the purpose of maximizing American Opportunity Credit (AOC). A scholarship is tax free only to the extent: It does not exceed qualified education expenses; It isn t specifically designated or earmarked for other purposes (such as room and board) and doesn t require that it can t be used for qualified education expenses; and It is not payment for teaching, research or other services as a condition for receiving it. Taxable scholarships are considered as earned income for the purpose of determining if a dependent must file a tax return and for calculation of the Standard Deduction. Taxable scholarships not reported on form W-2 are considered to be unearned income for the purpose of calculating Kiddie Tax, earned income credit and additional child tax credit. Who Must File (PUB 4012, Chart B, Page A-2) Children and Other Dependents: Single Under 65 not blind: You must file a return if any of the following apply: 1. Your unearned income was over $ Your earned income (includes taxable scholarship) was over $12, Your gross income was more than the larger of a. $1,050, or b. Your earned income (up to $11,650) plus $350. Standard Deduction for Dependents (PUB 4012 Page F-2) The below method assumes the dependent is single, under age 65 and not blind. See PUB 4012 for additional details. 1 Enter Earned Income (include taxable scholarships) 2 Additional Amount $350 3 Add line 1 and 2 4 Minimum Standard Deduction $ Enter the larger of line 3 or 4 6 Amount for single filing status $12,000 7 Standard Deduction is smaller of line 5 or 6 Affordable Care Act Considerations - Anytime a dependent has a filing requirement, you must include the dependent s income in the household income on the parent s return. This will potentially increase the Shared Responsibility Payment and lower the Premium Tax Credit. 1

2 Tax for Certain Dependents who have Unearned Income (Kiddie Tax) Starting in 2018, the Kiddie Tax and Form 8615 are in scope for AARP (PUB 4012 page H-2). For , the Tax Cuts and Jobs Act (TCJA) revamps the Kiddie Tax rules to tax a portion of an affected child s or young adult s unearned income (includes taxable scholarship) at the rates paid by trusts and estates. Those rates can be as high as 37% or as high as 20% for long-term capital gains and qualified dividends. Before the TCJA, the Kiddie Tax rate equaled the parent s marginal rate (which for 2017 could be as high as 39.6% or 20% for long-term capital gains and qualified dividends). The TCJA only changes the Kiddie Tax rate structure. The rest of the Kiddie Tax rules are the same as before. Under the Kiddie Tax rules for , a portion of a child s net unearned income can be taxed at the federal income tax rates paid by trusts and estates. This is unfavorable, because the trust and estate rate brackets are compressed compared to the brackets for a single individual. So the Kiddie Tax hit on a child with substantial unearned income (includes taxable scholarship) can be significant. The Kiddie Tax applies when all of the following requirements are met: 1. The child s unearned income (including taxable scholarship) was more that the threshold ($2100 for 2018). If the threshold is exceeded, only unearned income in excess of the threshold is hit with the higher Kiddie Tax. 2. The child is required to file a return for the tax year. 3. The child was either: a. Under 18 at the end of the year, or b. Age 18 at the end of the year and did not have earned income that was more than half of their support*, (support does not include amounts received as scholarships), or c. A full time student at least age 19 and under age 24 at the end of the tax year and did not have earned income that was more than half of their support* (support does not include amounts received as scholarships). 4. At least one of the child s parents is alive at the end of the tax year. 5. The child does not file a joint return for the tax year. * One of the rules to be a qualifying child is the child cannot provide more than half of their support (except for EIC). PUB 929, Tax Rules for Children and Dependents, Figure 2 has a flow chart that details the above requirements and may be easier to follow see the last page. How to avoid the Kiddie Tax In order to avoid the Kiddie Tax, the child must not meet any one of the above requirements. At the time of the tax return, there is little that can be done other than when manipulating qualified educational expenses and taxable scholarships to maximize the American Opportunity Credit. Due to the different ways that taxable scholarship is treated, the only simple option is keeping under the filing threshold of $12,000 for earned income (including taxable scholarship). For applicable 2018 returns, one will need to test the various options for dependent students with large scholarships. 2

3 Calculating the Kiddie Tax (Don t worry, Tax Slayer does this for you with correct entries.) First, add up the child s net earned income and net unearned income. Then subtract the child s standard deduction to arrive at taxable income. The portion of taxable income that consists of net earned income is taxed at the regular rates for a single taxpayer. The portion of taxable income that consists of net unearned income (includes taxable scholarship) and that exceeds the unearned income threshold ($2,100 for 2018) is subject to the Kiddie Tax and is taxed at the rates that apply to trusts and estates Trust and Estate Rates for Ordinary Income (Income Other Than LTCGs and Qualified Dividends) 10% tax bracket $0-2,550 Beginning of 24% bracket $2,551 Beginning of 35% bracket $9,151 Beginning of 37% bracket $12, Trust and Estate Rates for LTCGs and Qualified Dividends 0% tax bracket $0-2,600 Beginning of 15% bracket $2,601 Beginning of 20% bracket $12,701 Example 1: Child/dependent with both earned and unearned income (no taxable scholarship) and owes Kiddie Tax. For 2018, Gina (age 17) has $2,000 of earned income from a W-2 and $7,000 of unearned ordinary income from ordinary dividends ($1,000), short-term capital gains ($2,000), and interest ($4,000). Her standard deduction is $2,350 (based on her $2,000 of earned income + $350). Gina s taxable income is $6,650 ($2,000 + $7,000 $2,350 standard deduction). Of the $6,650 of taxable income, $4,900 ($7,000 unearned income - $2,100 unearned income threshold) is taxed at the trust and estate tax rates under the Kiddie Tax rules. The first $2,550 is taxed at 10%, resulting in $255 of tax. The next $2,350 ($4,900 - $2,550) is taxed at 24%, resulting in $564 of tax. The other $1,750 of Gina s taxable income ($6,650 - $4,900) is taxed at the 10% regular rate for a single taxpayer, resulting in $175 of tax. So Gina s federal income tax bill totals $994 (Kiddie Tax of $255 + $564 + regular tax of $175). Without the Kiddie Tax, all of Gina s $6,650 of taxable income would have been taxed at 10% under the regular rates for single taxpayers, resulting in only $665 of tax. Example 2: Child/dependent/student with earned income, unearned income from taxable scholarship and owes Kiddie Tax. For 2018, May (age 22 and a full time student) has $10,000 or earned income on a W-2. In order to maximize her AOC, she will shift $7,000 of her unrestricted scholarships to taxable scholarship. Her standard deduction is $12,000 (taxable scholarship is considered earned income for the Standard Deduction calculation). Her taxable income is $5,000 ($10,000 + $7,000 - $12,000 standard deduction). Of the $5,000 of taxable income, $4,900 [$7,000 unearned income (includes both unearned income and taxable scholarship) - $2,100 unearned income threshold = $4,900] is taxed at the trust and estate tax rates under the Kiddie Tax rules. The first $2,550 is taxed at 10%, resulting in $255 of tax. The next $2,350 ($4,900 - $2,550) is taxed at 24%, resulting in $564 of tax. 3

4 The last $100 of Mary s taxable income ($5,000 - $4,900) is taxed at the 10% regular rate for a single taxpayer, resulting in $10 of tax. So Mary s federal income tax bill totals $829 (Kiddie Tax of $255 + $564 + regular tax of $10) Without the Kiddie Tax, all of Mary s $5,000 of taxable income would have been taxed at 10% under the regular rates for single taxpayers, resulting in only $500 of tax. The education credit (AOC) taken on the parent s return, from shifting scholarship to taxable scholarship, will likely be more advantageous even with this increased Kiddie Tax. Tax Slayer Entry Caution: Tax Slayer provides no warning if the Kiddie Tax applies - Form 8615 requires manual entry. Enter all income sources and other entries as normal. Enter taxable scholarship as Other Income / Other Compensation / Scholarships and Grants. Look at Summary/Print and this should show any calculated tax (Line 11) before applying Kiddie Tax rules this will normally be calculated at 10%. Two options to get to the Kiddie Tax form: Go to Other Taxes / Tax for Children Under Age 18 Form 8615 Search for Form 8615 and Go To the Form Make entries on Form 8615: Parent s First and Last Name and SSN and then Continue this triggers the Kiddie Tax calculation. Go to Summary/Print and you will notice the calculated tax (Line 11) may have changed to a larger value. In the full print, you will see the Form 8615 and a Line 7 Tax Computation Worksheet and these calculate the Kiddie Tax the same way as the above examples. There is also a Standard Deduction Worksheet for Dependents that shows how the Standard Deduction was calculated. Note to Pat M. put these Worksheets in the production print set! 4

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