When you have a child who is a US citizen, there are certain tax filing requirements that need to be considered and several factors that should be taken into account when making savings for the future. We examine the key areas that parents need to know to ensure their children stay tax compliant and also provide updates on the various tax reliefs that can be received.
US children – the importance of clarifying citizenship
A child born in the US will automatically be a US citizen. A child born outside the US to a US citizen parent, can also be a US citizen, but it is best to receive US immigration advice in these circumstances. A child can be a US citizen even if the child does not apply for a US passport. There are also a large number of “accidental Americans” that were born in the US due to parents being on a work assignment or on holiday. As a US citizen, US children must comply with the same tax rules as their parents, which includes worldwide taxation. It is possible to relinquish US citizenship but you normally need to wait until adulthood (18 years old) before this can be achieved.
US tax on dependents
Your child is your dependent for US tax purposes if they are a US citizen, under 19 (or 24 and in full-time education), and you pay more than half of their support. For years before 2018, you were able to claim a tax-free personal exemption for each of your children, which was deductible against taxable income. This is no longer the case as all personal exemptions have been scrapped from 2018.
US children are subject to US tax on their worldwide income. It is possible that your child will need to file their own US tax return, however in many cases you are able to elect to include your child’s income on your tax return, if they are your dependent and meet other conditions.
If your child's interest, dividends and other unearned income totals more than $2,100 (for 2018), amounts exceeding this may be subject to “kiddie tax” rates. The idea behind these rules is to prevent parents sheltering assets in their children’s name to benefit from the lower rates of tax. From 2018 onwards, if your child’s unearned income is in excess of $2,100 it will be taxed at rates applicable to trusts and estates, rather than at personal Income Tax rates. Trust rates hit the same top rate as individual rates (37%), but at $12,500 taxable income rather than $500,000. Earned income for dependents is taxed at their own marginal personal rates.
Case Study: The kiddie tax
Darren is a US person, and his daughter Daisy is also a US person. Daisy is 16 and Darren is dependent and therefore subject to the kiddie tax rules. Daisy earns $500 from a paper round. She also received $3,000 bank interest in 2018. Daisy will pay tax on the $500 at personal tax rates, and be subject to a tax rate of 15% on the interest income, after the $2,100 exclusion is given. If she was not caught by the kiddie tax rules, her income would have been fully covered by her own standard deduction and no tax would have been due.
US tax relief for parents
You may be able to claim a Child Tax Credit of up to $2,000 per qualifying child under the age of 17. This is the maximum credit you can claim in 2018, double the amount in 2017, but is subject to income limitations.
Tax credits can also be given for qualifying childcare expenses. The amount of relief available is dependent on your adjusted gross income.
Other filing requirements
Children must comply with IRS overseas filing obligations in the same that way you do. This includes the requirement to file a Foreign Bank Account Report, where the aggregate value in their non-US accounts exceeds $10,000 at any point in the tax year. If they hold shares in your non-US company, they may also have to file Form 5471, though it is possible for you to do so on their behalf.
Saving for their future – college plans
A tax effective way of saving for your children’s future can be achieved by setting up a section 529 college plan. This enables you to save for their future college costs in a tax effective way, as funds used for “qualifying higher education expenses” are not taxed. Income earned in the plan does not need to be reported on you or your child’s tax return. This can also be a good way of gifting funds to your children for estate planning purposes, without giving them the ability to control the funds.
As these plans are held under trust, care should be taken to ensure the plan does not become a UK resident trust, which could create a UK tax burden. If your child does not go to college there will be a tax charge on future distributions from the plan. If your child goes to a UK college there could be a tax charge on the child in the UK at the time of distribution of funds from the trust.
As always, UK-US taxpayers should consider the taxation by both countries for all income.
Due to its tax-free status, creating a Junior ISA for your child can look appealing from a UK tax perspective. However, the IRS will not recognise its tax-free status and income will be taxable in full.
There are similar anti-avoidance principles in the UK with regards to reporting and taxation of your child’s income. If your child gets more than £100 interest from money sources given by a parent, the parent will pay Income Tax on all of the interest.
UK childcare tax saving schemes, such as employer childcare vouchers will save UK tax, however will not achieve the same saving in the US, which could lead to US tax due on such benefits. Note that from April 2018 employer childcare vouchers will be replaced with a new tax-free childcare scheme managed through NS&I. Childcare vouchers will continue to operate alongside the new scheme but will be closed to new scheme entrants from 6 April 2018. We expect the new 20% top up of childcare from the government to be seen as tax relief, so an adjustment to foreign tax credits would be required.
US children need to comply with the US tax rules in the same way that an adult would. There is no minimum age to become a US taxpayer. The IRS has anti-avoidance provisions in place to ensure taxpayers cannot avoid tax by holding assets in their children’s names. UK and US taxpayers should be mindful of schemes beneficial in one country, that can cause a tax issue in the other.
The full Stepping Stones series can be found here
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