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Monday, August 21, 2017

5 Things to Know About Taxation of Children With Investment Income


Many of our clients have created savings or investments accounts for their children. Some have also set up a wealth and succession plan in which minority interests in businesses are owned by their kids. If you fall into either of these categories, here are five things you should know about children with investment income.

1. When do I need to worry about this?
If you have an investment account in your child’s social security number, you may have to report the income it generates. The IRS requires that if your dependent’s only income is “unearned income” (can be used synonymously with “investment income”), they must file a return if the income is more than $1,050. Unearned income includes interest, dividends, capital gains and any other income that is investment-related. This would also include pass-through income from entities such as partnerships, S-corporations and trusts.

2. My child needs to file a tax return?
Believe it or not, the IRS generally holds the child responsible for filing his or her own tax return and paying the corresponding tax on that return. If the child cannot file his or her own return for any reason (such as their age) the child’s parent or legal guardian must file it for them. If your child’s investment income is greater than the threshold mentioned above, they would be required to file a return.

Because children are typically in a lower tax bracket, Congress was concerned that income-producing assets would be shifted to them in order to take advantage of lower tax rates. To safeguard against this, if a child’s unearned income is more than $2,100, part of that income may be taxed at your (higher) tax rate instead of their (lower) tax rate.

As a general rule (for calendar years 2015 and 2016):
  • The first $1,050 of a child’s investment income is not taxed at all.
  • The second $1,050 of a child’s investment income is taxed at their rate.
  • Investment income in excess of $2,100 is taxed at the parent’s rate instead of the child's rate.
It's important to note that the child’s earnings from employment would not be taxed at the parents’ tax rate.

3. Can I just report their income on my tax return?
Yes, in many cases! To avoid filing a return for your child, you may elect to report their income on your tax return if your child’s gross income was less than $10,500 and they only had income from interest and dividends (including capital gain distributions). Some other conditions must also be met―notably, that your child was under the age of 19 at the end of the year (or 24 if a full-time student), and no backup income tax was withheld or estimated tax payment made in your child’s name during the year.

4. Which is better, filing a separate return for my child or reporting their income on my return?
The answer to this question is not so straightforward. If you make the election, your child may not be able to take certain deductions available to them if they had filed separately. In addition, since their income is included on your return, it may:
  • Increase your net investment income tax
  • Reduce certain credits or deductions available to you as a result of your increased adjusted gross income
  • Make you subject to a penalty for underpayment of estimated tax if you did not factor in their income in your calculation of estimated taxes
On the flip side, including their income on your return eases the burden and expense associated with filing a separate return. Your tax advisor can help you determine which option is best.

5. If I’m divorced, which parent has to report the income?
The IRS provides rules for this; unfortunately, you can’t just pick which parent’s return to use. If you are divorced (or legally separated), had custody of your child for the greater part of the year (are the custodial parent) and are not remarried, you should use your return. If you are the custodial parent and are remarried, the step-parent (not the noncustodial parent) is treated as the child’s other parent, and you should use your joint return to report the income.

If you are the custodial parent, are remarried and file a separate return, use the return of the one with the greater taxable income. The noncustodial parent should not report their child’s investment income on their return.

If you are married and do not file a joint return, or if you are not married but lived together with your child’s other parent all year, you would also use the return of the parent with the greater taxable income.

To learn more about the taxation of your child’s investment income, contact your Armanino advisor.

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