The Kiddie Tax Problem

You may have heard that there are issues with the new kiddie tax.

There are.

The kiddie tax has been around for decades.

Standard tax planning includes carving out highly-taxed parental or grandparental income and dropping it down to a child/young adult. The income of choice is investment income: interest, dividends, royalties and the like. The child starts his/her own tax bracket climb, providing tax savings because the parents or grandparents had presumably maxed out their own brackets.

Congress thought this was an imminent threat to the Union.

Which beggars the question of how many trust fund babies are out there anyway. I have met a few over the decades – not enough to create a tax just for them, mind you - but I am only a tax CPA. It is not like I would run into them at work or anything.

The rules used to be relatively straightforward but hard to work with in practice.

(1)  The rules would apply to unearned income. They did not apply if your child starred in a Hollywood movie. It would apply to the stocks and bonds that you purchased for the child with the paycheck from that movie.

(2)  The rules applied to a dependent child under 19.

(3)  The rules applied to dependents age 19 to 23 if they were in college.

(4)  The child’s first $1,050 of taxable unearned income was tax-free.

(5)  The child’s next $1,050 of taxable unearned income was taxed at the child’s tax rate.

(6)  Unearned income above that threshold was taxed at the parent’s tax rate.

It was a pain for practitioners because it required one to have all the returns prepared except for the tax because of the interdependency of the calculation.

For example, let’s say that you combined the parents and child’s income, resulting in $185,000 of combined taxable income. The child had $3,500 of taxable interest. The joint marginal tax rate (let’s assume the parents were married) at $185,000 was 28%. The $3,500 interest income times 28% tax rate meant the child owed $980.

Not as good as the child having his/her own tax rates, but there was some rationale. As a family unit, little had been accomplished by shifting the investment income to the child or children.

Then Congress decided that the kiddie tax would stop using this piggy-back arithmetic and use trust tax rates instead.

Problem: have you seen the trust tax rates? 

Here they are for 2018:

          Taxable Income                         The Tax Is

Not over $2,550                         10%

$2,551 to $9,150         $ 255 plus 24% of excess

$9,151 to $12,500       $1,839 plus 35% of excess

Over $12,500              $3,011.50 plus 37% of excess

Egad.

Ahh, but it is just rich kids, right?

Not quite.

How much of a college scholarship is taxable, as an example?

None of it, you say.

Wrong, padawan. To the extent not used for tuition, fees and books, that scholarship is taxable.

So you have a kid from a limited-means background who gets a full ride to a school. To the extent the ride includes room and board, Congress thinks that they should pay tax. At trust tax rates.

Where is that kid supposed to come up with the money?

What about a child receiving benefits because he/she lost a parent serving in the military? These are the “Gold Star” kids, and the issue arises because the surviving parent cannot receive both Department of Defense and Department of Veteran Affairs benefits. It is common to assign one to the child or children.

Bam! Trust tax rates.

Can Congress fix this?

Sure. They caused the problem.

What sets up the kiddie tax is “unearned” income. Congress can pass a law that says that college room and board is not unearned income or that Gold Star family benefits are not unearned income.

However, Congress would have started a list, and someone has to remember to update the list. Is this a reasonable expectation from the same crew who forgot to link leasehold improvements to the new depreciation rules? Talk to the fast food industry. They will burn your ear off on that topic.

Congress should have just left the kiddie tax alone.

Is A Form 1099 Automatically Income?

I have a tax question for you.

It may seem straightforward, but this issue actually went to the Tax Court.

You bought a house in 2008. You took out a first and second mortgage.

During 2011 you fell behind on the mortgage. You caught up in 2012.

In 2014 you received a check for $13,508 from the mortgage company. Included with the check was a note stating

… based on a recent review of your account, we may not have provided you with the level of service you deserve, and are providing you with this check.”

The letter also stated you could call with any questions. You did but obtained no more information than we have above. You cashed the check.

The mortgage company sent a Form 1099-MISC for $12,789 and a 1099-INT for $719.

QUESTION: Do you have taxable income?

Several things are crossing through my mind.

(1)  First, if you deducted the $12,789 as mortgage interest, the recovery of a previous interest deduction can be taxable.

(2) Second, how would you know without further detail from the mortgage company?

(3) Third, is their reporting on a Form 1099 fatal?

I admit, I am thinking mortgage interest. To the extent the interest was previously deducted, its recovery could be taxable under the tax benefit doctrine.

The IRS has an easy argument.

Hey, you received a 1099. Two, in fact. A 1099 means income. If the 1099 is wrong, contact the mortgage company and have them void the 1099. Until then, as far as we are concerned you have income.

You have a tougher argument. You have to show that the monies are from a nontaxable source, but the mortgage company is not exactly baring its soul here.

You show the Court the letter. You point out that you paid both principal and interest on the mortgage. It is possible that the mortgage company is repaying you for principal it overcharged.

Did you rise to the occasion?

Here is the Court:

We hold that petitioner presented credible evidence that the $12,789 was a reimbursement for a mistake that [...] had made on his accounts. This return of $12,789 of petitioner’s mortgage payments was not a taxable event and the amount is therefore not includible in income.”

All parties agree that the $719 is taxable as interest income.

You did a good job, but you had a big break.

The IRS presented nothing other than they had received two 1099s. Most of the time that is a winning play.

But you could trump it by providing enough doubt that the 1099s sprung from a taxable source.

You did.

You may have had a sympathetic Court, though. You see, you served in the U.S. Army, and you were serving in Africa as you caught up on your mortgage during 2012.

The Court wouldn’t say, of course. We have to read between the lines.

Our case this time is Jin Man Park v Commissioner.