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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.