Determining education tax credits and the taxability of scholarships is an issue often encountered in tax planning and preparation. CPAs may be unaware that taxable scholarships can be subject to the kiddie tax and even the alternative minimum tax (AMT). Alarmingly, many tax preparation software packages either miss the issue entirely or give confusing diagnostics that do not include the fact that the kiddie tax applies to taxable scholarships. In addition, relying on Form 1098-T, an IRS mandated informational form, might result in an incorrect determination of the taxability of scholarships and education tax credits. Fortunately, Congress recently passed new legislation that should resolve this last issue and result in 1098-T reporting that is useful in calculating education information in the future.
The Kiddie Tax
Congress enacted a tax on “unearned child income” in 1986 to discourage parents from shifting investment income to their children in order to take advantage of a child’s lower marginal tax rates [Committee Report on Tax Reform Act of 1986 (TRA), PL 99-514]; this has been dubbed the “kiddie tax.” Originally, the kiddie tax applied to children younger than age 14 who had unearned income above a certain threshold (TRA). In 2005, the Tax Increase Prevention and Reconciliation Act increased the age children became subject to the kiddie tax from under 14 to under 18 (PL 109-222). The Small Business and Work Opportunity Tax Act of 2007 amended the provision once again to children younger than age 18, children who are 18 whose earned income does not exceed half of their support, and students ages 19 to 23 whose earned income does not exceed half of their support. For 2015, the kiddie tax applies to any qualified child that has unearned income more than $2,100, does not file a joint tax return, and has at least one parent living at the end of the year (Revenue Procedure 2014-61).
Older children are more likely to have income from sources that do not meet the definition of earned income or investment income.
Under section 1(g)(4) of the 2007 act, the kiddie tax is calculated based on net unearned income. For 2015, net unearned income is total unearned income less $1,050 (the minimum standard deduction for a dependent), less another $1,050 or allowable itemized deductions directly connected with the production of the unearned income, whichever is greater (Revenue Procedure 2014-61). Section 1(g)(4)(B), however, limits net unearned income to overall taxable income for the child.
Under section 1(g)(4)(A), any income that is not earned income is potentially subject to the kiddie tax. Earned income, defined under Internal Revenue Code (IRC) section 911(d)(2), consists of wages, salaries, and other similar amounts received as compensation for personal services rendered. Under the original age requirement, the kiddie tax likely caught only investment income which Congress was concerned that parents might be shifting to their children. As the age limit increased, however, so did the likelihood that the child would have more types of unearned income. This problem increased when Congress raised the age to conform to the dependency requirements. Older children are more likely to have income from sources that do not meet the definition of earned income or investment income. These changes increase the likelihood that the kiddie tax will be assessed against income, such as scholarships, not targeted by the original legislation.
Kiddie Tax Confusion
Given the original purpose of the kiddie tax, CPAs may incorrectly think that the tax only applies to investment income. IRS forms, instructions, and publications may have perpetuated this thinking. Prior to 2006, Form 8615 was titled “Tax for Children Under Age 14 Who Have Investment Income of More Than…” From 2006 through 2012, the title still included “Investment Income”; beginning in 2013, the IRS changed the form’s title to “Tax for Certain Children Who Have Unearned Income.” Similarly, until 2013 Line 1 of the form instructed taxpayers to “Enter the child’s investment income.” The form now correctly instructs taxpayers to “Enter the child’s unearned income.”
In addition, for many years the relevant instructions only provided examples of what constituted investment income; other unearned income was not mentioned. Coinciding with the changes to Form 8615 in 2013, the IRS changed the related instructions to give examples of what constituted unearned income. Included in the revised listing for the first time were taxable scholarships and fellowship grants not reported on Form W-2.
There was no change in the case law, code, regulations, or any other administrative rulings related to the kiddie tax to prompt the revisions in the form and instructions. Furthermore, the “what’s new” section of the instructions did not mention the changes made to the form or instructions by the IRS.
The calculation of a dependent’s standard deduction also adds to the confusion of taxable scholarship treatment. The standard deduction for a dependent for 2015 is the greater of $1,050 or the dependent’s earned income plus $350 (not to exceed the basic standard deduction amount for the dependent’s filing status). While taxable scholarships are unearned income for kiddie tax purposes, under Proposed Regulations section 1.117-6(h) they are considered earned income for calculating a dependent’s standard deduction. Proposed Regulations section 1.117-6(h) allows students to consider taxable scholarships as earned income for only two purposes: when determining the standard deduction for a dependent and when determining whether a dependent must file a tax return. Under IRC section 6012(a)(1)(C), dependents must file a tax return when unearned income (not including taxable scholarships) exceeds $1,050 (for 2015), plus any additional standard deduction allowed or when total gross income exceeds the total standard deduction. This has little effect on the kiddie tax, since taxable scholarships are earned income for purposes of calculating the standard deduction and net unearned income is limited to taxable income. This contradictory treatment of taxable scholarships between two different tax provisions adds to the confusion of taxable scholarship treatment for kiddie tax purposes.
Taxable Scholarships and the Kiddie Tax
The following three examples illustrate the net unearned income calculation for the kiddie tax. In all examples, the student is a dependent, filing as single with no itemized deductions related to unearned income. Exhibit 1 presents the results.
Kiddie Tax Examples
Alice’s only income is $1,000 in taxable scholarships. Because her unearned income is less than $2,100, no kiddie tax is due. Ben’s only income is $5,000 in taxable scholarships. The $2,100 ($1,050 + $1,050) reduction to unearned income to arrive at net unearned income gives him preliminary net unearned income of $2,900. Net unearned income is, however, limited to taxable income. Ben’s standard deduction is the greater of $1,050 or earned income plus $350. For standard deduction purposes, taxable scholarships are earned income, so Ben has an actual standard deduction of $5,350 ($5,000 + $350), reducing his taxable income to zero. Thus, the kiddie tax does not apply.
Like Ben, Chandra has taxable scholarships of $5,000, but also has income reported on Form W-2 of $7,000. Again, her preliminary net unearned income is $2,900. Her earned income plus $350 exceeds the standard deduction for the single filing status, however, so her standard deduction is limited to $6,300. With taxable income exceeding the preliminary net unearned income, Chandra has net unearned income of $2,900. Given her taxable income of $5,700, $2,900 will be taxed at her parents’ marginal tax rate, with the remaining $2,800 taxed at Chandra’s rate.
CPAs often rely on their tax software to handle routine calculations correctly. Based on a sampling of four leading professional tax software packages, however, it is apparent that some software providers are also confused about the application of the kiddie tax rules to taxable scholarships. To test the software packages, a $10,000 taxable scholarship was entered for a dependent student with no other income or deductions.
One tax package gave no alert or diagnostic that preparers should even consider the kiddie tax. Even if the parents’ tax information was entered, no kiddie tax was calculated. A second tax package gave no alert or diagnostic that preparers should consider the kiddie tax, but did calculate the kiddie tax correctly if the parents’ tax information was entered. A third software package gave a diagnostic that read, “If the taxpayer is age 18 and has earned income less than half the taxpayer’s support, or a full-time student age 19–23 with earned income less than half the taxpayer’s support, and has over $2,100 of investment income, Form 8615 may be required” [emphasis added]. Since the student had only a taxable scholarship, the preparer would correctly conclude that they have no investment income, but incorrectly conclude that the kiddie tax does not apply. Instead of using “investment income,” the diagnostic should have used “unearned income.” The final software package tested did give a diagnostic useful to practitioners: “Taxpayer’s age and unearned income indicate Form 8615, Tax for Certain Children Who Have Unearned Income, may be required.” These differing results demonstrate that CPAs must understand the kiddie tax thoroughly in order to calculate the correct tax treatment for their clients, since their tax software may not be helpful.
Alternative Minimum Tax
Under IRC section 55, the AMT can apply to children subject to the kiddie tax. While their AMT income is calculated the same as other taxpayers’, IRC section 59(j) limits the AMT exemption for those subject to the kiddie tax to earned income plus $7,400 for 2015 (Revenue Procedure 2014-61). The AMT is most likely to apply when the child has a high-taxable scholarship, little or no earned income, and parents with a 15% or lower top marginal tax rate. As shown in Exhibit 2, a student with a $10,000 taxable scholarship, no earned income, and parents with a 15% top marginal tax rate would pay an additional $121 in tax because of the AMT.
Kiddie Tax and AMT Example
Form 1098-T and its Impact on Taxable Scholarships and Education Credits
Calculating both taxable scholarships and education credits requires an accurate calculation of education expenses. With the creation of tax credits for education expenses in 1997, Congress realized that both taxpayers and the IRS needed informational reporting from educational institutions to determine and verify the amount of eligible credits. Initially, reporting requirements were very basic, and only information about the institution and the students’ classification was required (IRS Cumulative Bulletin Notice 97-73).
In 2000, the Treasury Department proposed regulations that required institutions to report payments received for qualified expenses during the calendar year on Form 1098-T [Proposed Regulations section 1.6050S-1, Explanation 1 (July 3, 2000)]. In response, numerous educational institutions argued that it would be difficult for them to report amounts received for qualified expenses. They argued that a student’s account was a “running balance of undesignated payments and reimbursements,” and their accounting systems could not apply payments and reimbursements to specific charges [Proposed Regulations section 1.6050S-1, Explanation 1.B(i) (April 29, 2002)]. These institutions requested that there be an option to report either payments received or amounts billed during the calendar year.
Seemingly in agreement with the institutions’ requests, Congress amended the IRC, and the Treasury updated the regulations in 2002 (PL 107-131 and TD 9029). Under the new rules, institutions could choose to report either the net amount of payments received or the net amount billed during the calendar year. The majority of institutions elected to report amounts billed rather than payments received (from a search of 30 selected institutions, all but one reported amounts billed). Because taxpayers can only take an education credit based on education expenses actually paid and not for expenses billed to them, taxpayers that used Form 1098-T through 2015 to calculate education credits or deductions most likely calculated them incorrectly. Even though the IRS instructions actually warn against using Form 1098-T to calculate education expenses, some CPAs and self-preparers might still use the expenses billed from Form 1098-T to calculate education benefits, believing that they can rely on the form. Alternatively, they may recognize that they should not rely on Form 1098-T but believe that the numbers it provides are close enough to the actual eligible expenses, or that using them would result in only a timing difference. Neither of these beliefs is true. Depending upon the situation, using the amount billed to calculate qualified education expenses can result in claiming less education credit than the taxpayer is entitled to, credit for expenses never paid, or more taxable scholarship than is correct.
Fortunately for future tax returns, eligible education expenses will be much easier to calculate. Passed by Congress on December 18, 2015, the Protecting Americans from Tax Hikes (PATH) Act amends IRC section 6050S and removes the option to report the net amount billed on the Form 1098-T for years beginning after December 31, 2015 (PL 114-113). In Announcement 2016-17, the IRS indicated it will not impose penalties on educational institutions that do not comply with the new rule for 2016 calendar year reporting after many expressed the need for more time to comply with the rule change. When fully implemented, this rule change will take a form that often provided unhelpful information and mandate that educational institutions provide information that is useful for preparers, taxpayers, and the IRS in calculating qualified education expenses.
The kiddie tax, the AMT, and education credits all complicate the process of saving and paying for a child’s education. CPAs can help parents by informing them of the various regulations and pitfalls, as well as keeping themselves aware and not simply relying on automatic tax software when preparing returns.