Life insurance proceeds and the kiddie tax; minimizing the liability

National Public Accountant, The, Sept, 1990 by Clifford E. Hutton, Darlene A. Smith

Life Insurance Proceeds and the Kiddie Tax

Minimizing the Liability

Recent tax law changes have significantly impacted the taxation of children's unearned income. The Tax Reform Act of 1986 added a provision to tax a portion of a child's unearned income at the parent's highest marginal tax rate. It also added a provision to disallow the personal exemption and limit the standard deduction on the return of an individual who can be claimed as a dependent on another taxpayer's return. The Technical and Miscellaneous Revenue Act of 1988 (TAMRA) added a provision to allow a parent to include a child's unearned income on the parent's tax return rather than file a separate return.

The primary objective of the "kiddie tax" was to prevent the reduction of a family unit's tax by transferring assets (and the income from the assets) to minor children. However, the tax applies to unearned income of a child under 14 years of age regardless of the source of the assets generating the income.

A common situation which will result in the application of this tax occurs upon the death of a parent of young children. Life insurance proceeds may pass not only to the surviving spouse but also to the children. In addition, the children may also receive Social Security benefits. Sec. 86(1) requires inclusion of a portion of Social Security benefits in gross income in some cases.

The purpose of this article is to examine the application of these provisions to a family where a parent has died, leaving significant life insurance proceeds to both the surviving spouse and to the children.

Taxation of Social Security Benefits

Sec. 86 requires the inclusion of a portion of Social Security benefits in the gross income of high income individuals. The amount that must be included in gross income is the lesser of:

1. 50% (Social Security

benefits), or 2. 50% (modified adjusted gross

income plus 50% of Social

Security benefits minus a base

amount).

Modified adjusted gross income is generally adjusted gross income plus tax-exempt interest received. The base amount is:

1. $32,000 for married

taxpayers filing jointly, 2. $0 for married taxpayers

filing separate returns, 3. $25,000 for all other

taxpayers.

Social Security benefits received by a child are attributed to that child and may potentially be included in that child's gross income.(2) The base amount for minor children would be $25,000.

Unearned Income of a Minor Child

Sec. 1(i), as enacted by TRA '86 and amended by TAMRA, requires the net unearned income of a child under the age of 14 at the close of the taxable year be taxed at the marginal tax rate of the parent. Sec. 1(i)(4) defines net unearned income as unearned income less the sum of:

1. The standard deduction

allowed under Sec. 63(c)(5)(A)

to a taxpayer who may be

claimed as a dependent on

another tax return -- currently

$500(3), and 2. The greater of the $500

standard deduction or, if the child

itemizes deductions, the

amount of the deductions

which are directly connected

with the production of the

unearned income.

As Sec. 1(i)(4) reads, the $500 amounts apply to any child under 14 even if that child may not actually be claimed as a dependent on another's tax return. However, net unearned income is limited to taxable income of the child by Sec. 1(i)(4)(B).

To illustrate, assume Mr. A died on December 31, 1988, leaving a widow and three small children, ages 1, 3 and 5. In A's will the spouse inherits $500,000 cash which is invested at an average return of 9%. Each child receives $50,000 which is also invested at an average return of 9%. Social Security benefits amount to approximately $1,600 per month ($400 per family member) or an annual amount of $19,200.

During the next two years, Mrs. A will be considered a surviving spouse, assuming she meets the requirements of Sec. 2(a).(4) (See Table 1.) Afterwards, Mrs. A will file as a head of household. (See Table 2.)

Election to Include Child's Net Unearned Income on Parent's Return

TAMRA added Sec. 1(i)(7) which allows a parent to include a child's net unearned income on the parent's return. If the parent so elects, the child will be treated as having no gross income for the year and will not be required to file a tax return. The election can be made only if the child:

1. Has gross income for the

taxable year only from

interest and dividends, 2. Such gross income is more

than $500 and less than

$5,000, and 3. No estimated tax payments

for such year are made in the

name of such child and the

child is not subject to back-up

withholding.

In addition to including the child's net unearned income in gross income, the parent must pay an additional tax of the lesser of:

1. $75, or 2. 15% of the child's gross

income over $500.

Since at the level of gross income allowed under this section no Social Security benefits would be included in gross income, it can be assumed that this election can be made for children receiving interest, dividends and Social Security benefits. It is not clear whether the parent would be required to include the child's Social Security benefits in the parent's computation of includable gross income under Sec. 86. Sec. 1(i)(7)(B)(iii) specifically includes the child's tax preference for municipal bond interest in the parent's computation of alternative minimum tax. Sec. 1(i)(7)(C) directs the secretary to prescribe regulations "necessary to carry out the purposes" of the provisions. It is probable that the regulations will require the child's Social Security benefits to be included in the parent's Sec. 86 computations.