Change In The Kiddie Tax

Congress took a tax calculation that was already a headache and made it worse.

I am looking at a tax change included in the year-end budget resolution.

Let’s talk again about the kiddie tax.

Years ago a relatively routine tax technique was to transfer income-producing assets to children and young adults. The technique was used mainly by high-income types (of course, as it requires income), and the idea was to redirect income that would be taxed at a parent’s or grandparent’s (presumably maximum) tax rate and tax it instead at a child/young adult’s lower tax rate.

As a parent, I immediately see issues with this technique. What if one of my kids is responsible and another is not? What if I am not willing to just transfer assets to my kids – or anyone for that matter? What if I do not wish to maximally privilege my kids before they even reach maturity? Nonetheless, the technique was there.

Congress of course saw the latent destruction of the republic.

Enter the kiddie tax in 1986.

In a classroom setting, the idea was to slice a kid’s income into three layers:

(1)  The first $1,050

(2)  The second $1,050

(3)  The rest of the kid’s income

Having sliced the income, one next calculated the tax on the slices:

(1)  The first $1,050 was tax-free.

(2)  The second $1,050 was taxed at the kid’s own tax rate.

(3)  The rest was taxed at the parents’ tax rate.

Let’s use an example:

(1)  In 2017 the kid has $20,100 of income.

(2)  The parents are at a marginal 25% tax rate.

Here goes:

(1)  Tax on the first slice is zero (-0-).

(2)  Let’s say the tax on the second slice is $105 ($1,050 times 10%).

(3)  Tax on the third slice is $4,500 (($20,100 – 2,100) times 25%).

The kid’s total 2017 tax is $4,605.

Let’s take the same numbers but change the tax year to 2018.

The tax is now $5,152.

Almost 12% more.

What happened?

Congress changed the tax rate for slice (3). It used to be the parent’s tax rate, but starting in 2018 one is to use trust tax rates instead.

If you have never seen trust rates before, here you go:

          

Have over $12,500 of taxable income and pay the maximum tax rate. I get the reasoning (presumably anyone using trusts is already at a maximum tax rate), but I still consider these rates to be extortion. Sometimes trusts are just that: one is providing security, navigating government programs or just protecting someone from their darker spirits. There is no mention of maximum tax rates in that sentence.

Let’s add gas to the fire.

The kiddie tax is paid on unearned income. The easiest type to understand is dividends and interest.

You know what else Congress considered to be unearned income?

Government benefits paid children whose parent was killed in military service. These are the “Gold Star” families you may have read about.

Guess what else?

Room and board provided college students on scholarship.

Seriously? We are taking people unlikely to be racking Thurston Howell III-level bucks and subjecting them to maximum tax rates?

Fortunately, Congress – in one of its few accomplishments for 2019 – repealed this change to the kiddie tax.

We are back to the previous law. While a pain, it was less a pain than what we got for 2018.

One more thing.

Kids who got affected by the kiddie tax changes can go back and amend their 2018 return.

I intend to review kiddie-tax returns here at Galactic Command to determine whether amending is worthwhile.

It’s a bit late for those affected, but it is something.

Vacation Or Business Deduction?

Let’s say that we work together. I cannot attend an appointment with a new client first thing in the morning. You volunteer to cover for me.

By the way, welcome to tax practice. Believe me, it is not the glitz and glamour that Hollywood makes it out to be. I know: hard to believe.

You meet the Fishers. They are both attorneys, he as partner in a firm and she as a sole practitioner. They have three children, all under the age of 10. She takes her kids to work periodically for the customary reason: the cost of day care and family members unable to care for the kids at the time.

She had an opportunity to represent a client in the Czech Republic for a few weeks, and she took it. It turned out however that he was unable to watch the kids. Seeing herself in a jam, she took the kids with her but came up with a novel twist:

She would write a travel book about the Czech Republic. It would be written to and for kids and would lessen their tedium while travelling.

She had no previous writing experience, so this was new territory. It occurred to her that other parents might be interested in such books – and this could be a business opportunity for a sharp and motivated person.

She has kept this up now for three years. She has now taken the kids to Disney World as well as to several cities in Europe.

You talk to her about the IRS and its “hobby loss” rules. She is an attorney, not a writer; there is a gigantic personal enjoyment factor present, ….

She cuts you off. Remember: she is an attorney. She has read up on this area of tax law, and she thinks she meets the requirements. For example,

·        She consulted with one of her clients, a published author, who gave her advice on both writing and publishing.

·        That person introduced her to a book distributor, who suggested she hire a graphic designer. She did so.

·        She also consulted with a friend who works at HarperCollins; the friend recommended she hire an agent. She has not done that yet.

·        She completed four prototype books, but has not submitted them for publication. She has instead self-published. Sales however have been minimal.

The Fishers need to file returns for the last three years. Her combined loss from the book-writing activity is approximately $75,000.

They ask whether you can prepare their returns and claim the book-writing loss.

What do you say?

The big issue is whether the activity rises to the level of a tax deduction. You remember some of the factors that the IRS uses to identify a hobby:

·        Not run in a business-like fashion

·        Failure to consult experts

·        Failure to revise business plans when losses pile up

·        Profits dwarfed by the losses

But Ms. Fisher has been meeting people. She has made contacts at a publishing house. She has written prototypes. She has self-published. She seems to be getting some things right.

You don’t see a clear-cut answer. Two people can reasonably disagree. The problem of course is that the IRS has a bit more horsepower than the average person you might disagree with.

You wobble. You tell them that you want to review the literature in this area, as the issue is walking the grey lands. You will call them tomorrow.

We have a chance to talk about the meeting.

I see two things immediately:

(1)   Can we prepare and sign the return under professional standards?

(2)   If so, there is still a significant chance that they would lose the deduction on audit.

Professional standards allow a tax practitioner some leeway when confronted with certain issues. This is fortunate, or professional practice would likely grind to a near halt.  The bar can be higher or lower depending upon the particular issue under discussion. Take a “listed transaction,” for example, and the bar is pretty high. Listed transaction is jargon for tax shelter, and we are nowhere near that with the Fishers. Our bar is much lower.

However, I would say our best chance with the IRS is 50:50, and likely less than that.  We would discuss this with the client and allow them to decide. It is their return, after all. Maybe they will get another accountant’s opinion. Maybe I am wrong.

This is a real case, by the way.

The Fishers are from New York and took this issue to Tax Court.

They lost.

The Court decided that her activity was not so much a business as her investigating going into business. The Court pointed out a few things: she had not hired an agent, had not finalized a book, and had not submitted a proposal to a publishing house. Since business activity had not started, it did not have to consider whether the activity was a hobby.

No business activity = no business deduction.

What do I think?

The Court saw too much personal and not enough business. I suppose that had she been making money the Court may have relented. She had to clear the hurdle of deducting what many people would see as vacations, and that required some serious weight on the other end of the see-saw to sway the Court.