Changes to U.S. “Kiddie Tax” Rules

With both the increases in Canadian personal tax rates, over the last few years, and the new changes to the tax on split income (TOSI) rules, many Canadians are reviewing ways to effectively split income between family members in order to lower the family’s combined taxes.  With Canadian prescribed rates slated to increase from 1% to 2% on April 1, 2018, many Canadians are rushing to set up loans to family trusts at the 1% prescribed rate. If you’re an American who is resident in Canada, you may want to slow down. If you already have a prescribed rate loan in place you may want to consider repaying it. If either the contributor or beneficiaries of the trust are U.S. persons, recent changes in the U.S. may reduce the overall impact of this strategy.

Since January 1, 1987, the United States has imposed a “kiddie tax” on the unearned income of certain children. The Tax Cut and Jobs Act has changed, effective January 1, 2018, how this tax is computed.

In general, unearned income is defined as the excess of the portion of the adjusted gross income (“AGI”) for the taxable year which is not attributable to earned income.  The term “earned income” means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered including self-employment income.  Unearned income is meant to capture investment income such as interest, dividends, rents, royalties, annuities and capital gains, etc.

The kiddie tax applies to a (U.S.) child if either of the following two conditions are true:

  • the child has not reached age 18 by the end of the taxable year; or
  • the child has not reached age 24, their earned income is not more than one-half of their support, and they must be a full-time student;

U.S. kiddie tax applies unless all three of the following conditions are true:

  1. the child is required to file a return for the year;
  2. the child has at least one parent alive at the close of the taxable year; and
  3. the child will not file a joint return for the taxable year.

Under the previous legislation there were two possible methods to compute this additional tax liability.  With either method, essentially, the tax on the unearned income was computed at the parent’s marginal tax rate.

The first method allowed the parents to include the net unearned income, of all affected children, on the parent’s U.S. personal income tax return.

The second method determined an “allocable parental tax” which was then included on the child’s tax return.  In general, the “allocable parental tax” represented the child’s portion of the additional tax that would have been paid by the parents if the child’s, and other effected children’s, unearned income was taxed on the parent’s U.S. personal tax return.  This would have represented the marginal tax increase.

The IRS had issued temporary regulations which outlined various family scenarios to assist in determining which parent’s tax return would be used as the base in computing the “allocable parental tax”.  One scenario, that the Regulations do not address, is the situation where there is a U.S. child but both parents are non-resident aliens.  This would happen, for example, if the parents were in the U.S. on a temporary basis (work assignment, attending school, etc.) and had the child while there were temporarily resident in the United States.  It does not appear that the IRS has provided any guidance as to whether the U.S. kiddie tax rules would apply to the U.S. child and, if it does, any guidance as to how it would apply.

Effective January 1, 2018 that is a moot point.  The computation of the U.S. kiddie tax no longer refers to the taxable income nor the actual U.S. tax of the parents.  Instead the kiddie tax must now be computed under the estate and trust tax table.    These tables provide for very compressed brackets where by the top marginal rate of 37% is reached for taxable income in excess of US $12,500.  Qualified dividends and long term capital gains (LTCG) still qualify for the lower marginal tax rates but the 15% rate is maxed out at US $12,700.  Any LTCG and qualified dividends would then be taxed at the maximum 20% rate.

Given that Canadian personal marginal tax rates may exceed 50%, there are instances where planning may still result in overall tax savings.  Cadesky U.S. Tax can assist in helping you understand the impacts of these rules and to assist in any required planning.

TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.

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