Major changes to the “kiddie tax” could significantly increase the tax liability of assets placed in special needs trusts if the trust's beneficiary is a minor and the income the trust earns is high enough.
Congress enacted the so-called “kiddie tax” in 1986 to deter wealthy families from “income splitting” — shifting some of their assets to other relatives, such as their children, so income on the assets can be taxed at a lower rate. The kiddie tax provision of the Internal Revenue Code taxes unearned income from minors differently than other unearned income. Unearned income generally refers to non-wage income, such as income from capital gains, dividends, or assets placed in a trust, including a special needs trust (SNT) for children with disabilities.
Up until now, the Internal Revenue Services (IRS) automatically taxed all unearned income from children above $2,100 in the same tax bracket applicable to their parents' income. Under the new rules, enacted as part of the Tax Cuts and Jobs Act of 2017, the IRS instead taxes unearned income above this threshold at the greatly compressed tax rates for trusts.
Trust income is taxed at a far steeper rate than personal income. For 2018, personal income is not taxed at the highest (37 percent) tax rate until a person's income exceeds $510,000. But trust income is taxed at the highest tax rate when the trust income exceeds just $12,500.
However, there are ways this higher tax liability can be mitigated. If the child's assets are from a personal injury award or settlement, the assets could be funneled to the SNT through a structured settlement. Assets in structured settlements that provide ongoing payments over a contracted-for period of time, rather than as a lump sum, are tax free. Pooled trusts are also an option.
For the purposes of the kiddie tax, minors are defined as people under age 18, or if 18, until the completion of that school year. People are still considered minors up to age 24 if they are in school. The kiddie tax does not apply if the minor is filing taxes jointly, as is sometimes the case when the minor is married or if neither of the child's parents is alive.
There are ways to lower the kiddie tax other than buying a structured settlement annuity. Contact your special needs planner to discuss how to reduce taxes on your child's special needs trust in light of the new tax law.