Kiddie Tax – What The Parents Don’t Know May Still Hurt Them

Take-Away: The Kiddie Tax can often pose a tax-trap for parents, especially if their teens spend considerable time on their cellphones and computers quietly trading in digital currency.

Background: The Kiddie Tax is part of the Tax Code. The Kiddie Tax is intended to discourage wealthier individuals from transferring assets to the child to take advantage of their child’s lower marginal income tax bracket. [IRC 1(g).]

Dependent Child: The Kiddie Tax applies to a dependent child who is under the age of 18 years at the end of the tax year. It also applies to a child who is a full-time student who is younger than 24 years of age.

Income Threshold: Under the current rule a minor child’s unearned income, including capital gains distributions, dividends, and interest income, is taxed at their parents’ tax rate if that unearned income exceeds the annual limit of $2,300 in 2022. Unearned income is defined in the Tax Code in the negative,  as income that is not wages, salaries, or earnings that constitute a trade or business.

Application of the Kiddie Tax: The first $1,150 of unearned income is covered by the Kiddie Tax’s standard deduction, so this amount is effectively not taxed. The next $1,150 is taxed at the child’s marginal federal income tax rate. Anything above the $2,300 is taxed at the parents’ marginal income tax rate.

Earned Income: The Kiddie Tax does not apply to a child’s salary or wages earned by the child, which is taxed as ordinary income.[See IRS Publication with regard to the taxation of a minor child’s earned income, which can be fairly complicated.]

Reporting: A child’s unearned income is reported on IRS Form 8615, if any of the following conditions are met: (i) the child’s unearned income exceeds $2,300; (ii) the child was under the age of 18 at the end of the tax year; (iii) the child was age 18 at the end of the tax year and their parent did not have earned income that was more than half of the child’s support; (iv) the child was a full-time student at least age 19 and under age 24 at the end of the tax year and the child did not have earned income that was more than half of their parents’ support; and (v) at least one the child’s parents was alive at the end of the tax year. However, the child’s parents may elect to report their child’s interest income, ordinary dividends and capital distributions on the parents’ own tax return and thus avoid filing a tax return for the child. This election is filed on Form 8814 which is attached to the parents’ own Form 1040 return.

Net Investment Tax: If a parent is required to file From 8615 then the parent may be subject to the net investment income tax of 3.8% with regard to the child’s unearned income along with the ordinary income tax associated with the child’s unearned income.

Trade-or-Business Exception: Arguably a child who trades marketable securities could fall in the trade-or-business exception to the Kiddie Tax. However, as a broad generalization, any effort to manage investments does not amount to engaging in a trade-or-business. A stock trader will be considered to be in a trade-or-business (leading to ordinary earned income) if a two-prong test is met. First, the trading activity must be “continuous, regular, and substantial.” Second, the goal of the ‘trading’ activity is short-term profits based upon the fluctuations of the market .[IRC 911 and IRC 457(f).] Seldom will a minor child who owns their own marketable securities account meet the ‘trade-or-business’ exception and be treated as having earned income as a ‘day-trader.’

Income Tax Exposure: A taxpayer-parent has an obligation to accurately and correctly report all sources of their income. Does the parents’ teenager volunteer they that have substantial taxable gains from trading in cryptocurrencies, NFT’s, or the newest in-vogue  digital currency, altcoins? A teenager may not want to tell their parents about their gains  from trading cryptocurrencies on-line because they know their parents will tell them to do something that they do not want to with their money, like pay income taxes, or pay for their own college education, or pay for their own car. In short, successful investing in digital currency and NFTs is a topic that teens often conclude “what Mom and Dad don’t know won’t hurt them.” Ah, then again, there’s the Kiddie Tax.

Minor’s Accounts: If a UTMA or UGMA account is held in the child’s name, or a child-owned brokerage account, e.g. a Fidelity Youth Account, or a minor’s trust [IRC 2503] , these amounts of passive income can quickly add up and exceed the $2,300 unearned income threshold, thus causing the excess to be taxed at the parents’ marginal income tax rate. This is particularly true if the child has invested in mutual funds that make taxable distributions at the end of each year.

On-Line Trading: Not surprisingly, many minors who are proficient in IT and digital assets, are able to adroitly trade in cryptocurrency or NFT’s on-line, e.g. NFT Cryptopunks of digital artwork, or simply engaging in on-line investing in the afternoon after school.  Some have described this investing in virtual currency as ‘gamifying stock trading’ since it is easy and accessible, e.g. using mobile apps like Robinhood.) The most recent hot-market is teenagers who find fun trading in “altcoins,” often dozens of times a day, using their allowance money. Such trading in cryptocurrency, NFT’s, or altcoins creates at least two taxable events even if the trade only gains or loses a fraction of a cent per transaction: a sale and a purchase. A teenager will often trade in cryptocurrency or NFT’s because of the social component to it, coordinating with their friends, and collectively sharing their successes on Twitter or posts to Tik Tok. Teenagers who trade in virtual currencies are smart- it takes time, effort, and intelligence to figure out what is desirable and how to make money from it. And they do it all from their cellphone using multiple apps,  often, without the knowledge of their parents. In short, a teenager could generate substantial unearned taxable income over the calendar year without their parents’ knowledge.

Planning: Parents should directly ask their teen if they have virtual currency or any accounts at a virtual currency exchange. Parents should also ask to see their dependent’s cellphone or laptop, to discern if a virtual currency exchange’s app is downloaded- a good indicator that virtual currency trading is taking place. They should also view the home’s Wi-Wi history to identify what websites their teen is visiting; if there is significant time spent on virtual currency exchanges or virtual currency discussion forums, that is a good indication that virtual currency transactions are likely to have been made by the teen. Finally, a one-on-one discussion with the teen that focuses on the tax consequences of those profits (if any), and the legal reporting requirements imposed by the IRS, is likely to be a productive conversation.

Conclusion: It may be possible that the IRS may know about a teenager’s trades on a virtual currency exchange that executed trades before the teen’s parents learn of that activity. The odds of the IRS learning of a child’s trading activities before the parents is only going to increase as the virtual currency exchanges begin to  implement the enhanced reporting requirements imposed on them by the Bipartisan Infrastructure Bill of 2021. The Kiddie Tax is here to stay, and with the proliferation of virtual currency trading on-line, it could provide for higher income tax, and possibly interest and penalties, faced by the parents who remain unaware of their child’s after-school down-time on their laptop and cellphone.