Grown-Up Income Shifting: Yesterday’s Kiddie Tax Is Not Enough

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, which distorts children’s saving and investing decisions. At the same time, the kiddie tax does nothing to prevent the transfer of appreciated property to children, itself a significant means of income-shifting.

The Article concludes that, in order to more effectively prevent income-shifting while at the same time reducing its distortions on non-abusive decisions, the kiddie tax needs to grow up. A grown-up kiddie tax would apply only to income a child earned on assets received as a gift at her parents’ rate; all other income would be taxable to a child at her own rate. At the same time, the kiddie tax would be triggered based on when a child received the asset, not when she realized income. By replacing the current kiddie tax with the grown-up kiddie tax, the tax law will have better tools to police against income-shifting.

Number of Pages in PDF File: 36

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

JEL Classification: H24, K34

Accepted Paper Series