Tax-Motivated Income-Shifting and the Kiddie Tax

Abstract:     
In 1986, concerned that wealthy parents were sheltering some of their income from taxes by giving some portion of their securities portfolios to their children, Congress enacted the “kiddie tax,” which taxes a child’s passive income at the child’s parents’ tax rate. By doing so, Congress intended to reduce tax-motivated income-shifting. Since its passage, however, there has been little serious consideration of whether the kiddie tax successfully prevents the targeted income-shifting.

This Article reexamines the kiddie tax and concludes that it is both over- and underbroad. The kiddie tax subjects all of a child’s passive income, not just income resulting from tax-motivated income-shifting, to her parents’ higher tax rates. At the same time, the kiddie tax does nothing to prevent large categories of income-shifting, including the transfer of income-producing property to adults and the transfer of appreciated property to children or adults. Moreover, taxing a child’s passive income at her parents’ rate does not reflect economic reality; children and their parents do not necessarily comprise an economic unit. The distortions caused by the kiddie tax are not benign, moreover: as a result of the inefficiency of the kiddie tax, children are discouraged from saving and investing their money.

The Article concludes that the reason for the kiddie tax’s over- and underbreadth is that tax-motivated income-shifting is not primarily the result of the relationship between parents and children. Instead, it is the result of the income tax treatment of gifts. In order to more efficiently prevent tax-motivated income-shifting without discouraging children from investing and saving their money, Congress should repeal the kiddie tax and, instead, treat the giving of a gift as a taxable realization event to the donor and require a donee to include the receipt of a gift in gross income.

Keywords: income tax, kiddie tax, realization, income-shifting, economic unity, distortions, gifts, mark-to-market, efficiency, family, joint returns, savings, investment

JEL Classifications: H24, K34

Working Paper Series