Tricky Tax Compliance — Child's Investment Income

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Are you among those fortunate enough to have investment funds already established for your children to help secure their financial future? Are they receiving investment income from assets held in their names? If so, as a parent, you need to be aware of your special compliance obligations and potential tax liability related to your children's investment income.

The Internal Revenue Service (IRS) issued guidance to such parents to clarify their tax compliance obligations. Several important aspects to the rules affecting their children's investment income were highlighted. The real issues can be summarized in two questions: What tax rate applies in calculating the tax liability; and what forms do you use to report a child's investment income. Knowing these factors will help parents determine whether their child's investment income will be taxed at the parents' rate or the child's rate.

1. Investment Income Defined. Investment income includes interest, dividends, capital gains and other unearned income.
2. Investment Income Limitation The special rules with regard to compliance and tax rates apply only if the child has investment income for the 2009 tax year of more than $1,900
3. Applicable Tax Rate. Depending on the amount of unearned income they have, children with investment income may have part or all of this income taxed at their parents' marginal tax rate rather than at the child's marginal tax rate. This can mean the difference between a 0 or 10 percent tax rate for the child and as much as a 35 percent tax rate for the parents.
4. Age, Earned Income, and Student Status Requirements. Children that may be affected by the special provisions requiring investment income to be taxed at their parents' rate are those who fit into one of the following three categories for 2009:
• The child was born after January 1, 1992;
• The child was born after January 1, 1991 but before January 2, 1992, and has earned income that does not exceed one-half of his or her own support for the year; or
• The child was born after January 1, 1986, and before January 2, 1991, is a full-time student, and has earned income that does not exceed one-half of his or her own support for the year.
5. Forms for Reporting Child's Investment Income. If the child files his or her own tax return, but must calculate income tax using the parents' marginal tax rate, Form 8615, Tax for Certain Children Who Have Investment Income of More Than $1,900, must be filled out and attached to the child's federal income tax return. When certain conditions are met, a parent may be able to avoid having to file a tax return for the child by including the child's income on the parent's tax return. In this situation, Form 8814, Parents' Election To Report Child's Interest and Dividends, must be filled out and attached to the parent's federal income tax return.

More information can be found in IRS Publication 929, Tax Rules for Children and Dependents. This publication and Forms 8615 and 8814 are available at the IRS website or by calling 800-TAX-FORM (800-829-3676).

Posted March 5, 2010.