You might think a kid doesn't have to file his first federal tax return until he's finally launched and holds his first real job. Unfortunately you'd be wrong. The rules governing who must file a return are surprisingly complicated, and a teen might have to file if he has earned as little as $400 from babysitting or mowing lawns.
"People get nailed," says Sherrill Trovato, an enrolled agent in Yorba Linda, Calif. "They'll say, 'I'm only 18; I don't have to file a tax return.' But it's not driven by age; it's driven by income," she explains.
Moreover, some of those who should file and don't end up shorting themselves, not the government. How so? They lose out on claiming refunds of taxes withheld from their paychecks or miss out on refundable tax credits they might qualify for.
Whether you're a parent trying to figure out if your dependent kids should file returns, a college student, or a young worker out on your own, here's a primer on filing your first tax return.
The Basic Filing Threshold
If you're a dependent (that means someone else pays more than half your support, including college tuition, room and board) whether you have to file depends on not only the amount of income you have, but also the source of that income.
Here's the rundown: If you have earned more than $5,700 working as someone's employee, you have to file. If you have unearned income (from interest or dividends) of more than $950, you have to file or your parents can elect to put your income on their own return. (More on that later.) Finally, if you have a combination of earned and unearned income that totals more than $950 and at least $300 of that is unearned, then you have to file, says Mel Schwarz, a partner with Grant Thornton in Washington, D.C.
The Self-Employment Catch
Those are the basic thresholds for a dependent. Things get more complicated if a kid is self-employed. For the high-school lawn-mower, babysitter or dog-walker, the duty to file kicks in as soon as he or she earns $400 net. That's because Social Security and Medicare must be reported and paid as "self-employment" taxes on Schedule SE of the Form 1040 income tax return, even if no income tax is due. True, if a kid is paid in cash the IRS is unlikely to know about the income, and most dog-walkers, babysitters and lawn-mowers probably don't report. But if a teen works for someone else (say a lawn service) and gets paid $600 or more as an independent contractor, both he and the IRS will be sent 1099s reporting his earnings.
Either way--whether a 1099 is issued or not--self-employed folks are supposed to report what they earn on Schedule C of the 1040. If you or your paid-in-cash teen is reluctant to comply, remember that he can deduct expenses (say, printing flyers to advertise his lawn business, or getting the mower repaired) against the gross revenue he takes in, reducing his taxable net. (That net is what he pays self-employment taxes on.) Consider it a learning experience.
The Form 8814 Option
If a dependent child reaches the filing threshold and some of his income is earned, he must file a separate tax return. But if he has unearned income from interest and dividends only, and is above the $950 threshold, his income can be reported on Form 8814 of his parents' return (up to a $9,500 maximum).
Craig Eaton, a CPA in Tewksbury, Mass., says his clients are often surprised to learn about yet another twist: If a child has any potential gains at all--meaning if he has any sales of stocks or bonds, including those sold in a custodial account for him--he must file a separate return, including a Schedule D.
Gross stock sales are reported to the IRS by the broker on a 1099-B, so this reporting is required, even if the child had no gains from the sale as long as the child had total investment income, including gross sales, of more than $950. In one case last year, Eaton says, clients switched investment advisers and liquidated their 8-year-old's $300,000 portfolio so it could be reallocated by their new financial guru. The stocks were sold at a $2,000 capital loss, but the parents still had to file a separate 1040 for their child, complete with a Schedule D for gains and losses. True, the kid gets to carry the loss forward the same as anyone else. But there's a little gotcha here: If the child's only income the next year is a $500 capital gain, it sops up $500 of the carryover loss--even though this income would have been tax-free (since it was below $950) on its own.
The Independent Filing Threshold
What if a young person can't be claimed as a dependent on someone else's return? Then he doesn't have to file a return unless gross income from all sources is over $9,350. (Provided, that is, he's not netting more than $400 from self-employment income.)
The W-4 Trap
A teen who earns less than the filing threshold may want to file anyway if he had income taxes withheld from a paycheck and is entitled to a refund. "You always have to file if you want your money back," Schwarz notes.
To avoid unnecessary filing, Schwarz says, be careful about how your teen fills out his W-4 when he snags a new job. Often, he notes, a boss will mistakenly tell a teen to put down zero exemptions on the W-4 wage withholding form, and money will be withheld when it shouldn't be. Instead the young employee should write "EXEMPT" on line 7 to certify that he had no federal tax liability the year before and expects to owe no federal tax this year. It's the same procedure for state income taxes. Watch out for separate forms in some states. Schwarz laments he just got W-2s for his own teenagers saying the state of Virginia had withheld $2 for one kid and $3 for the other.
Claiming Your Credits
Another reason a young worker who doesn't have to file might want to is the many tax credits out there. A tax credit reduces any tax you owe dollar for dollar, and some credits are even "refundable"--meaning you can get money back even if you didn't pay any taxes.
If a college student paid more than half his own expenses, he might be able to grab the American Opportunity Credit--a $2,500 credit for college expenses, $1,000 of which is refundable. A student who, for example, is living off a part-time job and selling stocks given to him by grandma, might qualify.
Assuming he's not someone else's dependent, a young worker might also be able to claim the $400 refundable Making Work Pay Credit for 2010, or the refundable earned income tax credit.
The Parent Trap
A kid who is under 19 or under 24 and a full-time student and who has more than $1,900 of unearned income is subject to the kiddie tax: Unearned income above $1,900 will be taxed at his parents' (usually higher) tax rate. The parents must attach Form 8615 to their own return. Forbes contributor Kaye Thomas has a detailed explanation of the "kiddie tax" rules at his website, Fairmark.com.