What to Know About Kiddie Tax and Hiring Your Kids as Employees

Children in a household can provide tax relief in the form of child tax credit or dependent care credit. However, when there’s income attributed to your child, that could lead to scenarios that need some planning, in order to avoid undesirable outcomes.

Your child may not be old enough to vote yet, but if they’ve had any form of income, they may have to report it to the IRS, just like a regular taxpayer. Let’s delve into this a little more.

Income is of two types — earned and unearned. Earned income is compensation in the form of wages, salaries, and fees received, in exchange for services rendered. Unearned income includes income generated by property, such as interest, dividends, rents and royalties. Children may have UGMA, UTMA or brokerage custodial accounts, where dividends and interest can easily add up, affecting their tax rate.

The “kiddie tax”: A parent’s primer

This is when something called the “kiddie tax” comes into play. The kiddie tax rules were created to reduce the ‘income shifting’ mechanism – especially investment income – from higher-income family members (like parents) to lower-income family members (such as children) to take advantage of their lower tax brackets. 

It has been subject to different income tax treatment, with the most recent being taxed at the parent's marginal tax rate.

Calculating the kiddie tax

Kiddie tax applies when the child meets one of the following income and age requirements as of the end of the tax year:

• The child was either age 18 or under
• The child was a full-time student who’s within 19 to 24 years of age
• The child had more than $2,500 in earned income, and this earned income didn’t provide more than half of his/her support

How does the math work? Let’s take a look.

Earned income will be taxed at the child's rate above their applicable standard deduction, which is equal to their earned income plus $400 (or $1,250, whichever is greater), up to a maximum of $13,850 in 2023.

However, unearned income (i.e. investment income) is a more complicated formula. Unearned income from interest, dividends and capital gains are taxed in tiers defined by the IRS:

• For a child with no earned income, the amount of unearned income up to $1,250 is not taxed in 2023.
• The next $1,250 is taxed at the child's rate. 
• Any unearned income above $2,500 is taxed at the parents' marginal tax rate – which could vary between 10% to 37%.

Case study: Example of a kiddie tax calculation

Let’s run through an example. Betty is 16 years old, works as a cashier at a local coffee shop, and earns $6,000 as wages in 2023. In addition, her grandma had a UGMA account for her, generating $3,500 in dividend income.

Betty’s total income: 

Earned income ($6,000) + unearned ($3,500) = $9,500

Her standard deduction: 

Earned income ($6,000) + $400 = $6,400

Unearned income above $2,500 is taxed at the parent's marginal tax rate. In Betty’s situation, that would be:

Unearned income ($3,500) – $2,500 = $1,000

Let’s suppose her parents had a taxable income of $100,000 taxable income at a marginal tax rate of 22%. That would be $220 in taxes, based on this calculation:

$1,000 x 22% = $220

Remaining: Total income ($9,500) – standard deduction ($6,400) = $3,100 

Amounts in excess of $1,000 are taxed at the child’s rate, i.e., 10%, which equals $210 based on this calculation:

$3,100 – $1,000 = $2,100 

$2,100 x 10% = $210

So, the total tax due on her return would be: $220 + $210 = $430

As we have seen, computing the taxes on a child’s return when they have both unearned and earned income isn’t quite so straightforward.

Kiddie tax is reported on Form 8615 and is reported with the child’s tax return.

However, parents have the option to include the dividends, capital gains and interest on their return. If they make this election, their child won't have to file a tax return, and parents attach Form 8814 if their child meets the following criteria:

• Under age 19 (or under age 24 if a full-time student).
• Their gross income was less than $13850 for the tax year.
• Their child had income only from interest and dividends and didn’t otherwise meet the filing requirement.
• The parent is qualified to make the election.

How to get around kiddie tax

Rather than opening investment accounts, if the child has earned income, consider opening a ROTH, which can benefit from compounded returns while growing tax-free through the years. As custodians, parents can fund their child’s retirement account up to the max contribution limit of $6,500. Parents will be subject to the annual gifting limit for their child in this case.

Another option is to open a 529 college savings plan account, where the growth is tax-deferred and distributions are tax-free, if used towards qualified education expenses.

Hiring children

Parents who are also business owners can capitalize on tax savings by hiring their children for specific duties.

The IRS has a section dedicated to the tax benefits of hiring family members in your business.

Business owners can take deductions for ordinary and necessary business expenses incurred by hiring their children, while the child earns wages for performing services appropriate for his/her age and learns valuable skills and work ethic on the job.

Child employed by parents

Payments for the services of a minor child aren't subject to Social Security and Medicare taxes if the business is a sole proprietorship or a partnership in which each partner is a parent of the child. In addition, payments to a child under age 21 aren't subject to FUTA taxes (Federal Unemployment Tax Act). If wages are below the standard deduction ($13,850 for 2023) – then there’s no filing requirement and no federal taxes due. Such businesses, however, may still owe state unemployment taxes.

The parent can deduct these wages on their pass-through business entity return, reducing their taxable income. With no payroll taxes, no federal unemployment taxes, and potentially no federal tax, this can be a sweet deal.

However, either one parent or both parents have to be whole owners of the business, and the child has to be below the age of majority, in order to score this exclusion.

So, what’s the catch? Here are a few:

1. The work performed by your child employee should be ordinary and necessary for the business.
2. Real work. You should be hiring your kid to provide bonafide services. Teens are especially good candidates for marketing data entry, copywriting, administrative and customer service-related duties. Paying a 6-year-old for data entry is likely to raise flags within the IRS.
3. Reasonable wages. Pay wages that would be offered in the marketplace for a similar position. If you hire your kids, have detailed records of what they did and how much time they spent doing the tasks, and they need to be paid a rate commensurate with their age and ability, not an exaggerated rate.
4. Substantiate and document. Keep personal records and business records separate, to be proactive about a potential audit. Maintain records of hours, work performed and wages paid to your children for those services.
5. Follow state and FLSA (Federal Fair Labor Standard Acts) guidelines. The work being assigned should be age-appropriate to the relevant federal and state child labor laws. The business type will also determine if assigned activities are appropriate.
6. Support Test. As long as your child’s wages are not enough to meet more than half of their support and they’re under age 17, they can still be claimed as a dependent under the Child Tax Credit.
7. Student Aid. Income earned by your student child is assessed at a higher rate in their FAFSA application, potentially reducing their eligibility for college funding, if it’s around the corner.
8. Consider kiddie tax when combining your child’s earned and unearned income for the tax year. 

Tax efficiency can minimize headaches and save you a buck when providing for your children, both in the form of wages and investment income, when tax season rolls around.