Gift tax and kiddie tax treatments for tax year 2021

The tax law has become increasingly family focused in recent years, providing tax breaks for families with children including tax credits for children, tax breaks for child care, tax-favored accounts for education savings, and much more. However, to make the best use of these tax benefits, families must understand how they work. Here is an excerpt of the white paper “Tax strategies for families with children” that covers several of these child-centered tax benefits—and highlight tax strategies for maximizing tax savings and avoiding potential pitfalls. Feel free to pass this information on to clients to help them understand their options.

Parents or other family members may want to transfer cash or other assets to a child to be used for the child’s education or to build a nest-egg for the future. If handled carefully, a gifting strategy can cut taxes. However, parents or other donors should be alert to potential consequences of the gift tax and the so-called “kiddie tax.”

Gift tax

A gift tax is imposed on any transfer to an individual (other than one’s spouse), either directly or indirectly, where full consideration (measured in money or money’s worth) is not received in return (Code Sec. 2501). However, there are exclusions that can reduce or eliminate the gift tax.

Annual exclusion: The tax law provides an annual exclusion from gift tax for gifts to any donee during the tax year. The exclusion in indexed annually for inflation. For 2021, the exclusion is $15,000 per donee—or $30,000 for gifts made by a married couple (Code Sec. 2503(b); Code Sec. 2513). There is no limit on the number of donees for whom a donor can claim the annual exclusion or on the number of years it can be claimed.

Tuition or medical expenses. The gift tax does not apply to an amount paid directly to a qualifying educational institution for the donee’s tuition (but not for books, room and board, or other expenses), In addition, amounts paid directly to a medical provider to cover the donee’s medical expense are not subject to gift tax (Code Sec. 2503(e)).

Lifetime exclusion. The tax law provides a combined basic exclusion from estate and gift taxes. For 2021, the exclusion exempts up to $11.7 million of transfers from gift or estate tax. The exclusion is scheduled to drop to $5.49 million after 2025. However, large gifts given before then will qualify for the higher exclusion even if they exceed the exclusion in effect when the donor dies.

Tax strategies. Parents and other family members should strategize gift giving to minimize the gift tax liability—for example, by making large gifts over a period of years to take advantage of the annual gift tax exclusion.

If a gift is intended for a child’s college tuition, payments should be made directly to the educational institution to take advantage of the tuition exclusion. Contributions to a child’s qualified tuition plan (QTP) do not qualify for the tuition exclusion, but do qualify for the annual $15,000 gift tax exclusion. In addition, a donor can elect to treat a larger QTP contribution as made over five years. Thus, a contribution of up to $75,000 in 2021, treated as spread over 5 years, will qualify for exclusion if the election is made.

Kiddie tax

The kiddie tax is designed to prevent parents or other relatives from shifting investment income to a child in a lower tax bracket (Code Sec. 1(g)).

The kiddie tax applies to a child’s net unearned income if the child (1) is under age 19 or is a full-time student under age 24, (2) has at least one living parent, (3) has unearned income above a threshold amount of $2,200 for 2021 (indexed), and (4) doesn’t file a joint return with a spouse for the year. In the case of a child over age 17, the kiddie tax applies only if the child’s earned income does not exceed one-half of his or her support.

Under the kiddie tax, a portion of a child’s unearned income is tax free, another portion is taxed at the child’s income tax rate, and the remaining unearned income is taxed the marginal rate of the child’s parents. Thus, for 2021, the first $1,100 of a child’s unearned income is not subject to tax, the next $1,100 is tax at the child’s rate, and any additional unearned income is taxed at the parents’ tax rate (assuming that rate is higher than the child’s rate).

Unearned income subject to the kiddie tax includes interest, dividends, capital gains, rents, royalties, taxable scholarships, and the taxable portion of Social Security or pension benefits paid to the child. Earned income that is taxed at the child’s rate includes wages, salaries, or other amounts received as compensation for personal services.

Tax strategies. When gifting income-producing assets to a child, donors should consider the amount of income the assets will produce each year to minimize the kiddie tax on unearned income. In addition, since the kiddie tax does not apply to earned income, parents may want to put the child to work. Earnings from a part-time or summer job will be taxed at the child’s lower tax rate or may escape tax entirely if sheltered by the standard deduction for dependents (Code Sec. 63 (c)(5)). For 2021, the dependent standard deduction is the greater of $1,100 or earned income plus $350 (but not more than the regular standard deduction for singles of $12,550).

Moreover, for parents with a family-owned business this can be a particularly attractive tax strategy.

Editor’s note: Robin Gervais, EA, and Sarah Molouki, CPA, MS in Tax, contributed to this article.