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Chapter 32. Tax on Investment Income of Certain Minor Children

Introduction

This chapter discusses two special tax rules that apply to certain investment
income of a child under age 14:

∙   When a parent can choose to include the child's interest and dividend
    income on the parent's return so the child does not have to file a
    return, (see Parent's Election to Include Child's Income, later), and

∙   When a child's interest, dividends, and other investment income that is
    more than $1,200, is taxed at the parent's tax rate instead of at the
    child's (see Child's Return Filed, later).

For this purpose, the term "child" includes a legally adopted child and a
stepchild. These rules apply whether or not the child is a dependent.

These rules do not apply if:

∙   The child is not required to file a tax return (see Do I Have to File a
    Return? in Chapter 1), or

∙   Neither of the child's parents were living at the end of the tax year.

Related publication and forms.

This chapter refers to a publication and some forms that you may need.
The list of forms does not include Forms 1040, 1040A, and 1040EZ. For more
information, you may want to order the following:

    Publication 929, Tax Rules for Children and Dependents

    Form 8615, Tax for Children Under Age 14 Who Have Investment Income of
    More Than $1,200

    Form 8814, Parent's Election To Report Child's Interest and Dividends

Which Parent's Return to Use

The following discussions explain which parent's tax return must be used when
applying the special tax rules for the investment income of a child under
14. Only that parent can make the election described later under Parent's
Election to Include Child's Income, and only that parent's tax rate and other
return information are used in the computations explained later under Child's
Return Filed.

Child's parents married. If the child's parents are married to each other and
file a joint return, use the joint return to apply the special rules. If they
file separate returns, use the return of the parent with the greater taxable
income.

Parents not treated as married. If the child's parents are married but not
living together, and the parent with whom the child lives (the custodial
parent) qualifies to be considered unmarried, use the return of the custodial
parent. If the custodial parent does not qualify to be considered unmarried,
use the return of the parent with the greater taxable income.

For an explanation of how a married person qualifies to be considered
unmarried, see Head of Household in Chapter 2.

Child's parents divorced. If the child's parents are divorced or legally
separated, and the parent who had custody of the child for the greater part
of the year (the custodial parent) has not remarried, use the return of the
custodial parent to apply the special rules.

Custodial parent remarried. If the custodial parent has remarried, the
stepparent (rather than the noncustodial parent) is treated as the child's
other parent in applying the special rules. Therefore, the earlier discussion
under Child's parents married applies.

Child's parents never married. If the child's parents did not marry each
other, but lived together all year, use the return of the parent with the
greater taxable income to apply the special rules. If the parents did not live
together all year, the rules explained earlier under Child's parents divorced
apply.

Widows and widowers. Widows and widowers must use the rules explained earlier
under Child's parents divorced to apply the special rules.

Parent's Election to Include Child's Income

If you elect to include your child's interest and dividend income on your tax
return, the child is not required to file a return.

You can make this election for 1992 only if all the following conditions
are met.

1)  Your child was under age 14 at the end of 1992.

2)  Your child had income only from interest and dividends (including Alaska
    Permanent Fund dividends).

3)  The dividend and interest income was more than $500 and less than $5,000.

4)  No estimated tax payments were made for 1992 under your child's name and
    social security number.

5)  No federal income tax was withheld from your child's income under the
    backup withholding rules.

6)  You are the parent whose return must be used when applying the special
    tax rules for children under 14. (See Which Parent's Return to Use,
    earlier.)

How to elect. Make the election by attaching Form 8814, Parent's Election To
Report Child's Interest and Dividends, to your Form 1040 or Form 1040NR. (If
you file Form 8814, you cannot file Form 1040A or Form 1040EZ.) Attach a
separate Form 8814 for each child for whom you make the election.

Tax effect of election. Using Form 8814 does not affect the tax rate applied
to your child's income. Therefore, your family's total tax will usually be the
same, whether your child files a return or you include his or her income on
your return.

However, using Form 8814 may result in more total tax if your child could have
taken deductions you cannot take, or if you have items on your return that are
affected by your adjusted gross income. You should figure the tax both ways
before you decide which method to use.

Deductions you cannot take. If you use Form 8814, you cannot take any of
the following deductions that could have been taken on your child's return:

1)  Additional $900 standard deduction if your child was blind,

2)  Deduction for penalty on early withdrawal of your child's savings, and

3)  Itemized deductions (such as your child's investment expenses or
    charitable contributions).

Increased adjusted gross income. If you use Form 8814 to add your child's
income to yours, your increased adjusted gross income may reduce certain
items on your return, including the following:

1)  Deduction for contributions to an individual retirement arrangement

2)  Itemized deductions for medical expenses, casualty and theft losses, and
    certain miscellaneous expenses,

3)  Total itemized deductions,

4)  Credit for child and dependent care expenses, and

5)  Personal exemptions.

Penalty for underpayment of estimated tax. If you make this election for 1992
and did not have enough tax withheld or pay enough estimated tax to cover
the tax you owe, you may be subject to a penalty. If you plan to make
this election for 1993, you may need to increase your federal income tax
withholding or your estimated tax payments to avoid the penalty. See Chapter
5 for information.

Figuring Amount of Child's Income to Report

Step 1 of Form 8814 is used to figure the amount of your child's income to
report on your return. Only the amount in excess of $1,000 is added to your
income. Include the amount from line 5, of all your Forms 8814, in the total
on line 22, Form 1040 or Form 1040NR. In the space next to line 22, write
"Form 8814" and the total from line 5 of all your Forms 8814.

Alternative minimum tax. If your child received any interest from private
activity bonds that is a tax preference item, include it as a tax preference
item when figuring your alternative minimum tax. Get Publication 909,
Alternative Minimum Tax for Individuals, for information.

Capital gain distributions. Include in the total on line 2a, Form 8814 any
capital gain distributions your child received. Treat these capital gain
distributions in the same way as ordinary dividends, unless you file Schedule
D (Form 1040) to report capital gains and losses.

If you file Schedule D, part or all of these capital gain distributions
should be reported on that schedule (where they may be offset by your capital
losses). Get Publication 929, Tax Rules for Children and Dependents, and use
the worksheet under Capital gain distributions to figure the amount to report
on Schedule D and the amount to report on line 5, Form 8814.

Figuring Additional Tax

Step 2 of Form 8814 is used to figure the tax on the amount of your child's
interest and dividends that you do not include in your income ($1,000 or
less), minus $500. This tax is added to the tax figured on your taxable
income.

This additional tax is figured at the lowest tax rate (15%) on the smaller of:

1)  Your child's gross income minus $500, or

2)  $500 ($1,000 minus $500).

The tax cannot be more than $75 (15% * $500).

Include the amount from line 8, of all your Forms 8814, in the total on line
38, Form 1040, or line 36, Form 1040NR. On Form 1040, enter the total from
line 8 of all your Forms 8814 in the space provided next to line 38. On Form
1040NR, enter the total of the line 8 amounts in the space provided next to
line 36.

Child's Return Filed (Parent's Election Not Made)

Part of a child's investment income may be subject to tax at the parent's tax
rate if:

1)  The child was under age 14 at the end of 1992, and

2)  The child's investment income was more than $1,200.

If the child's parent does not or cannot choose to include the child's income
on his or her return, figure the child's tax on Form 8615, Tax for Children
Under Age 14 Who Have Investment Income of More Than $1,200. Attach the form
to the child's Form 1040, Form 1040A, or Form 1040NR.

On Form 8615, enter the names and social security numbers of the child and the
parent in the spaces provided. (If the parents filed a joint return, enter the
name and social security number of the parent who is listed first on the joint
return.) Check the box for the parent's filing status. Then figure the child's
tax on Form 8615 in these three steps:

    Step 1. Figure the child's net investment income.

    Step 2. Figure a tentative tax on the net investment income based on
    the parent's tax rate.

    Step 3. Figure the child's tax.

Alternative minimum tax. A child may be subject to alternative minimum tax
(AMT) if he or she has certain items given preferential treatment under the
tax laws or certain adjustments to taxable income that total more than a
base amount. See Alternative Minimum Tax in Chapter 31.

For information on special limits that apply to a child who files Form 6251,
see Limit on AMT under Alternative Minimum Tax in Publication 929.

Parent's return information. See Which Parent's Return to Use, earlier, for
information on which parent's return information must be used on Form 8615.
If the parent and the child do not have the same tax year, complete the form
using the information on the parent's return for the tax year that ends in
the child's taxable year.

If the information needed from the parent's return is not known by the time
the child's return is due (usually April 15), file the return using estimates,
or use an extension of time to file. If the information is not available,
the child (or the child's legal representative) can request it from the IRS.
See Parent's return information not available under Child's Return Filed in
Publication 929 for more information.

Figuring Net Investment Income

The first step in figuring a child's tax using Form 8615 is to figure the
child's net investment income. To do that, first figure the child's gross
(total) investment income.

Investment Income

Investment income generally includes all income other than salaries, wages,
and other amounts received as pay for work actually done. It includes
interest, dividends, capital gains, certain distributions from trusts,
and the taxable part of social security payments and pension payments.

Nontaxable income. For this purpose, investment income includes only amounts
that the child must include in total income. Nontaxable investment income,
such as tax-exempt interest and the nontaxable part of social security and
pension payments, is not included.

Sources of income. A child's investment income includes all income produced
by property belonging to the child, regardless of whether the property was
transferred to the child or purchased by the child, and regardless of when the
property was transferred or purchased or who transferred it. Investment income
includes amounts produced by assets the child obtained with earned income
(such as interest on a savings account into which the child deposited wages).

A child's investment income includes income produced by property given as a
gift to the child under the Uniform Gift to Minors Act.

Example. Phil Black, 13, received the following income:

       Dividends - $600

       Wages - $2,100

       Taxable interest - $1,200

       Tax-exempt interest - $100

       Net capital gains - $100.

Phil's investment income is $1,900. This is the total of the dividends ($600),
taxable interest ($1,200), and net capital gains ($100). His wages are earned
(not investment) income because they are pay received for work actually done.
His tax-exempt interest is not included because it is nontaxable.

Trust income. If a child is the beneficiary of a trust, distributions of
taxable interest, dividends, capital gains, and other investment income from
the trust are investment income to the child.

Net Investment Income

A child's net investment income is generally his or her gross (total)
investment income reduced by the sum of the following three items:

1)  Adjustments to income attributable to the investment income (such as
    the penalty on early withdrawal of savings), plus

2)  $600, plus

3)  The greater of $600 or the child's itemized deductions that are directly
    connected (defined later) with the production of his or her investment
    income.

Example 1. Eleanor, 8, has investment income of $16,000 and an early
withdrawal penalty of $100. She has itemized deductions of $1,100 that are
directly connected with the production of her investment income. Her net
investment income is $14,200. This is her total investment income of $16,000,
reduced by $1,800. The $1,800 is the sum of the early withdrawal penalty
($100), plus $600, plus the directly-connected itemized deductions ($1,100).

Example 2. Roger, 12, has investment income of $8,000, no adjustments to
income, and itemized deductions of $300 that are directly connected with his
investment income. His net investment income is $6,800. This is his total
investment income of $8,000, reduced by $1,200 ($600 + $600).

His investment income is reduced by $1,200 because he has no adjustments to
income and his directly-connected itemized deductions are not more than $600.

Directly-connected itemized deductions. Itemized deductions are directly
connected with the production of investment income if they are for expenses
paid to produce or collect taxable income or to manage, conserve, or maintain
property held for producing income. These expenses include custodian fees
and service charges, service fees to collect taxable interest and dividends,
and certain investment counsel fees. They are deducted on Schedule A (Form
1040) to the extent that they, plus certain other miscellaneous itemized
deductions, are more than 2% of adjusted gross income. See Chapter 30 for
more information about the 2% of adjusted gross income limit on miscellaneous
itemized deductions.

Net investment income limited to taxable income. A child's net investment
income cannot be more than his or her taxable income. If the child's taxable
income is less than the amount figured as previously explained, the child's
net investment income is the same amount as the taxable income.

Completing Step 1 of Form 8615

A child's net investment income is figured on lines 1 through 5 of Form 8615.

Line 1 (investment income). If your child had investment income only, enter
the adjusted gross income shown on the child's return. Adjusted gross income
is shown on line 32 of Form 1040 or line 17 of Form 1040A. Form 1040EZ cannot
be used if Form 8615 must be filed.

If the child had earned income, figure the amount to enter on line 1 of Form
8615 by using the worksheet in the instructions for the form.

However, if the child has excluded any foreign earned income or deducted
either a loss from self-employment or a net operating loss from another year,
use the worksheet in Publication 929 to figure the amount to enter on line 1.

Figuring Tentative Tax At Parent's Tax Rate

The tentative tax is the difference in the tax on the parent's taxable income
figured with and without the child's net investment income. Figure it as
follows:

1)  Figure the tax on the total of the parent's taxable income plus the
    child's net investment income at the parent's tax rate.

2)  Figure the tax on the parent's taxable income without including the
    child's net investment income.

3)  Subtract the tax in (2) from the tax in (1). This is the tentative tax.

When making these computations, do not take into account the child's net
investment income in figuring any exclusion, deduction, or credit on the
parent's return.

Special rule. See Trusts under Figuring Tentative Tax at Parent's Tax Rate in
Publication 929 for information about a special rule that may apply if the
parent is the grantor of a trust.

More Than One Child

If the tax return information of the child's parent is used on Forms 8615 for
other children (including adopted children and stepchildren), include the net
investment income of all these children when figuring the tentative tax. Then
allocate the tentative tax to each child according to the child's share of the
total net investment income.

If the net investment income of the other children is not available when the
return is due, either file the return using estimates or use an extension of
time to file. Extensions are discussed under Extensions of Time to File in
Chapter 1.

Allocation of tentative tax. Allocate the tentative tax to each child by
multiplying the total tentative tax by a fraction. The numerator (top number)
of the fraction is the child's net investment income. The denominator (bottom
number) is the total of the net investment income of all the children. The
result of each multiplication is that child's share of the tentative tax.

Example. The Oaks' two children, Bill and Patty, ages 11 and 12, have $2,000
and $3,000 of net investment income. Tax on their incomes must be figured at
their parents' rate. On Form 8615, Bill's and Patty's net investment incomes
are combined and the total ($5,000) is added to their parents' taxable income
shown on their joint tax return. The difference between (1) the tax figured on
the total of their parents' taxable income plus the children's net investment
income and (2) the actual tax on their parents' return is $1,750. This
difference (the tentative tax) must be allocated between Bill and Patty.

The amount allocated to Bill is $700.

         $2,000
         ------  x  $1,750 = $700
         $5,000

         The amount allocated to Patty is $1,050.

         $3,000
         ------  x  $1,750 = $1,050
         $5,000

Completing Step 2 of Form 8615

The tenative tax based on the parent's tax rate is figured on lines 6 through
13 of Form 8615.

Line 9 (tax figured on parent's taxable income plus children's net investment
income). How you figure the amount to enter on line 9 depends on whether there
is any net capital gain income included in the total on line 8.

Net capital gain income is the excess of net long-term capital gain over net
short-term capital loss.

The maximum tax rate on net capital gain income is 28% (rather than the
maximum 31% rate that applies to other income).

No net capital gain income on line 8. If there is no net capital gain income
included in the amounts on lines 5, 6, or 7, use the Tax Table or Tax Rate
Schedules to figure the amount to enter on line 9.

If the amount on line 8 is less than $100,000, you must use the Tax Table to
figure the amount to enter on line 9. If the amount on line 8 is $100,000 or
more, you must use the Tax Rate Schedules.

Net capital gain income on line 8. If there is net capital gain income
included in the amount on lines 5, 6, or 7, the tax on line 9 may be less
if you use Part IV of Schedule D, Capital Gains and Losses. You can use
Schedule D to figure the tax if:

        The parent's                                     The amount on
        filing status                AND                   Form 8615,
            is:                                         line 8, is over:

      ∙ Single                                            ∙ $51,900
      ∙ Married filing joint return
        or Qualifying widow(er) with
        dependent child                                   ∙ $86,500
      ∙ Married filing separate return                    ∙ $43,250
      ∙ Head of household                                 ∙ $74,150

See Publication 929, Tax Rules for Children and Dependents, for information
on how to complete Part IV of Schedule D. If you cannot use Schedule D, you
must use the Tax Table or Tax Rate Schedule, whichever applies, to figure
the amount to enter on line 9.

Figuring the Child's Tax

The final step in figuring a child's tax using Form 8615 is to determine the
larger of:

1)  The total of:

    a)  The child's share of the tentative tax based on the parent's tax
        rate, plus

    b)  The tax on the child's taxable income in excess of net investment
        income, figured at the child's tax rate, or

2)  The tax on the child's taxable income, figured at the child's tax rate.

Completing Step 3 of Form 8615

The child's tax is figured on lines 14 through 18 of Form 8615.

Line 15 (tax on excess of child's taxable income over child's net investment
income). Generally, you must use the Tax Table or Tax Rate Schedule X to
figure the amount to enter on line 15. However, if the amount on line 14 is
more than $51,900 and includes any net capital gain income, the tax on line
14 may be less if you use Part IV of Schedule D.

Net capital gain income on line 14. If there is any net capital gain income
included in the amount on line 1 and you can use Schedule D, you must figure
the amount of net capital gain on line 14 before you can complete Part IV of
Schedule D. See Publication 929.