The Kiddie Tax Isn’t Cuddly: It’s Complicated

Unless they have inherited a fortune, children pay a lower income tax rate on the first $2,200 of unearned income than their parents. Hence, High-Net-Worth/Ultra-High-Net-Worth (HNW/UHNW) clients often wish to transfer income-producing assets to their children. Transferring such assets is one way they can lower their taxable income and perhaps pay less income tax. If a child works part-time, that is earned income and taxed at the child’s rate.

Are there limits to how much you can transfer? Yes. The U.S. Congress capped the amount you could transfer by imposing the “Kiddie Tax.”

Rules Which Govern “The Kiddie Tax” Are Bedevilling

You begin by opening a Uniform Transfer to Minors account. This is known as a UTMA and has replaced the UGMA (Uniform Gift to Minors Act). UTMA allows for the contribution of more asset types than the UGMA allowed. All states have now adopted this law except for South Carolina.

Assets Used To Fund An UTMA Are Irrevocable Gifts

The assets you place in the account and the income they generate belong to the child. You are acting solely in a fiduciary capacity, and once you put money in the account, the child is the beneficial owner. The gift is irrevocable, so you cannot take it back.

Federal Income Tax Rules For UTMAs

The first $1,100 of unearned income to a child in a UTMA is exempt from Federal income tax. If your state has an income tax, it may or may not apply to UTMAs. Capital gains in an UTMA are considered unearned income.

The second $1,100 is taxed at the child’s income tax rate which will be lower than their parents. Previously, all unearned income above $2,200 was taxed at the marginal tax rate of the parents. But the Tax Cuts and Jobs Act (TCJA) of 2017 changed the Kiddie Tax rate for unearned income above $2,220 to the trust and estate tax rate, which is lower. Like a shuttlecock in a game of badminton, the SECURE Act of 2019 swatted the income tax rate back to the marginal tax rate of the parents.

The Age And College Exception When Claimed As A Dependent

When the child reaches the age of majority, he must change the name of the UTMA account into his name because the money now belongs to him. But what is the age of majority? We presume it is 18 because the U.S. Constitution was changed to allow citizens to vote beginning at age 18, but this is not the age of majority in every state.

More confusing, half of the states have an age of majority for receiving assets from a UTMA higher than the legal age of majority.

There is a table here. 

Nonetheless, when he/she turns eighteen, even if they haven’t received the assets because of state law, they must file their own 1040. However, they must pay the income tax rate of their parents on their unearned income from the account if they meet the following three criteria established by the IRS.

1) They are between the ages of eighteen and twenty-four.

2) They are attending college.

3) They are claimed as a dependent on the tax return filed by their parents.

You can’t open a UTMA and then forget about it. As a custodian, you must ensure everyone involved follows the Federal and State rules on these accounts. Who has the ultimate responsibility? You do.

Contributing Writer: Subject Matter Expert Charles McCain

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