Thanks to the recently enacted Tax Increase Prevention and Reconciliation Act, many taxpayers will be now be subject to the Kiddie Tax rules. Effective January 1, 2006, the Kiddie Tax net has been expanded to capture children under the age of 18. Under prior law the age threshold was set at 14.

What is Kiddie Tax? At one time, wealthy parents, in an effort to reduce their taxes transferred some of their investments to their minor children. Oftentimes, this income was either not taxed, as the income was below the taxpaying threshold, or it was taxed at the child’s low income tax rates. Congress got smart and closed this loophole by requiring that such investment income (generally interest, dividends and capital gains) of children be taxed at their parents’ top income tax rate. Thus the “Kiddie Tax” was born and it taxes interest, dividends and capital gains, over a certain amount, at the parents’ highest tax rate.

In 2006 this threshold is set at $1,700, therefore, any unearned income of the child over $1,700 is taxed at the parents’ top tax rate. While this is a bad thing for taxpayers, it was mitigated somewhat by the fact that it only applied to children under 14. With the new tax law change, the Kiddie Tax now applies to children under 18. That’s four more years of appreciation on investments that could likely create interest, dividend or capital gain income that exceeds the $1,700 threshold. The Kiddie Tax is computed by adding the child’s investment income to the income of their parents.

How does it work?

A child’s investment income is first reduced by an $850 (2006) standard deduction. The next $850 is taxed at the child’s tax rate, and the excess of investment income over $1,700 is taxed at the parents’ top tax rate. There are two filing methods:

1. The child files a separate 1040 attaching Form 8615 or

2. The parents report their child’s investment income on their Form 1040 attaching Form 8814.

Method #2 saves the separate filing of the child’s return and thus saves some tax preparation fees. This is particularly advantageous for parents who have more than one child subject to the Kiddie Tax, as all of the investment income of all their children is combined with the income of the parents. There are disadvantages with Method #2, including higher Adjusted Gross Income (“AGI”) for the parents, which can reduce certain deductions that are limited by AGI. Method #2 may also result in a higher tax than if the child filed separately, specifically in situations where the child has capital gain income, and where the child has itemized deductions (which are lost if the child reports their income on their parents’ return).

You may want to contact your tax preparer to see how the change in the tax law is going to affect you for 2006.