CRS Reports on Standard Deductions

                       CRS REPORT FOR CONGRESS

[1] Between 1954 and 1986, it was possible for both a parent and his or her child or full-time student to offset income through the use of the child's or student's personal/dependency exemption. Under a provision of the Reform Act of 1986 (TRA86), if the parent claims the exemption, the child or dependent student cannot claim their own personal exemption. However, the TRA86 also provided a standard deduction for children/students equal to the greater of $500 OR earned income up to the full standard deduction applicable to other types of taxpayers. These amounts are adjusted annually for inflation. A provision included in the Taxpayer Refief Act of 1997 (TRA97) preserves a full offset for earned income against the standard deduction amount but also provides a more generous offset where there is both earned and unearned income. Beginning in tax year 1998, this provision allows children/students a standard deduction amount equal to the greater of $700 ¹ OR the sum of earned income and up to $250 of unearned income, not to exceed the standard deduction amount. The 1998 standard deduction amount for single taxpayers is $4,250. ² The $250 unearned income amount is indexed for inflation after tax year 1998. If a child's or student's income exceeds these amounts, then the child/student must file a tax return. Special tax rules commonly referred to as the "kiddie tax" apply to the unearned investment income of children under the age of 14. This report does not discuss the kiddie tax and thus -- strictly speaking -- only applies to children and students 14 or over. The author plans to update this report annually to reflect the most recent indexation adjustments.

BRIEF HISTORY

[2] Before 1954, if a child or student earned more than $600 (the amount of the personal exemption at the time), then the parent lost the ability to claim a dependency exemption for the child/student.

[3] The Internal Revenue Code of 1954 made the personal exemption available to both the parent and child/student. Otherwise, children/students who worked part-time to help pay the cost of their education could cause the loss of the dependency exemption to their parents, even though the parents still provided more than half the child's/student's support. Thus, between 1954 and the passage of the Tax Reform Act of 1986 (TRA86), it was possible for both the parent and child/student to offset income by claiming a personal/dependency exemption for the same person.

[4] Under provisions introduced by the TRA86, if the parent claims the dependency exemption, the child/student cannot also claim it. The TRA86 provided a standard deduction amount for children/students equal to the greater of $500 (combination of earned and/or unearned income) OR earned income up to the generally applicable standard deduction amount. The indexed $500 amount stands at $700 for tax year 1998 while the indexed standard deduction amount is $4,250.

[5] The Taxpayer Relief Act of 1997 (TRA97) modified the standard deduction of dependents as a simplification measure. The Act increases the standard deduction to the greater of $700 (the prior $500 amount adjusted for inflation) or the sum of $250 and earned income, but not to exceed the full standard deduction. Thus, under provisions of the act, children/students with earned incomes greater than $700, but less than the standard deduction amount who have small amount of unearned income (up to $250) will no longer have the unearned income taxed nor have to file a tax return. This change became effective for tax year 1998.

INTERRELATIONSHIP BETWEEN THE PERSONAL/DEPENDENCY EXEMPTION AND STANDARD DEDUCTION

[6] Under existing law, adult taxpayers who do not itemize deductions can reduce their adjusted gross incomes by a personal exemption and a standard deduction, both of which are adjusted annually for inflation. In 1998, the amount of the personal exemption is $2,700. The amount of the standard deduction varies according to filing status. In 1998, the standard deduction amounts are $4,250 for those filing single, $6,250 for those filing as ahead of household, and $7,100 for those married taxpayers filing jointly. The standard deduction is thought of as a proxy for itemized deductions. Because tax policy recognized that children/dependent students are not completely separate from their parents, there have often been limitations on the kinds and amounts of income that children/students could receive tax free -- including limitations imposed by restricting exemptions and deductions.

[7] Under prior law (the Internal Revenue Code of 1954), the standard deduction or former zero-bracket amount could offset earned income of a child/student, but not unearned income such as interest and dividends. Unearned income, however, could be offset by the personal exemption. While the TRA86 eliminated the personal exemption for children/students who were claimed as dependents on a parent's return, it did permit a child/student an offset of up to $500 in the form of a partial standard deduction. This partial deduction could be used against unearned income. This original $500 amount has been subject to an inflation adjustment (and stood at $650 in tax year 1997). In 1998, the modification made by the Taxpayer Relief Act of 1997 takes effect, and the maximum standard deduction for children and dependent students is the greater of $700 (regardless of composition) or earned income plus $250 (up to $4,250). ³

[8] The personal exemption amount stood at $1,080 prior to the 1986 change with the law providing that unearned income of a child/student could be offset against that amount. But, the 1986 Act no longer allowed a personal exemption to the child/student when claimed on a parent's tax return. At the same time, however, the TRA86 permitted a partial standard deduction to children/students. So, for 1998, the child/student with no earned income is able to shelter up to $700 of unearned income. This $700 amount (the result of the original $500 amount being subject to an inflation adjustment) will continue to be adjusted in future tax years.

[9] In the case of children/students who had $1,080 or more in unearned income and had earned income, it can be said that the amount of wages that can be offset has risen from $2,480 before the 1986 Act (the zero bracket amount [ZBA] for single individuals) to $4,250 in 1998 (an increase of $1,770). However, for those children/students who only had earned income the amount has only risen from $3,560 (the former ZBA amount plus the personal exemption amount) to $4,250 (an increase of only $690). These dollar amounts are in nominal terms and are not a reflection of inflation adjusted amounts.

[10] In those cases where the child's/student's income exceeds $700 of earned/unearned income OR $4,250 in earned income (whichever is greater), filing a separate tax return will be necessary for the child/student for tax year 1998. Often, it is necessary to file a separate return even when the child's/student's income falls below these levels to receive a refund of taxes previously withheld.

[11] The enactment of the Taxpayer Relief Act of 1997 will result in increases in the offsets for some children/students beginning in tax year 1998. Thus, in some cases, greater tax relief will be provided through larger standard deductions for those with incomes composed of both earned and small amounts (less than $250) of unearned income. In addition, those taxpayers will no longer have to file a tax return, unless it is required in order to reclaim amounts withheld in taxes.

FIVE-TEST ELIGIBILITY FOR DEPENDENCY EXEMPTION

[12] To claim a dependency exemption FOR ANY PERSON under present law, five tests must be met.

1. GROSS INCOME TEST -- a taxpayer cannot claim a person as a

[13] As noted in the summary, the information provided in this report applies to children between the ages of 14 and 18 as well as full-time students between the ages of 19 and 24. ⁴ The Internal Revenue Code defines a full-time student as a student who attends an educational organization at least during each of 5 calendar months of the taxpayer's calendar year. This 5-month period is not required to be consecutive. Individuals may be classified as students if they attend either an educational organization or if they pursue a full- time course of institutional on-farm training under the supervision of an accredited agent or an educational organization. The Code defines an educational organization as one that maintains a "regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on." ⁵

RATIONALE FOR CHANGE

[14] While not expressly stated in the explanation of the Tax Reform Act of 1986 ⁶ prepared by the staff of the Joint Committee on Taxation, it may be inferred that the rationale for the 1986 change in the personal/dependency exemption was threefold. One is consistency: no other exceptions are available for a person to be claimed as an exemption on more than one tax return; the general rule can be simply stated as one personal exemption per person. The second reason is that the combination of the personal exemption and the standard deduction is designed to provide a safety net to those near the poverty threshold. The intention is that those individuals near the poverty line would not be obliged to pay federal income taxes. Income of dependents does not relate to the poverty threshold in the same way; for example, a child with little income of his or her own may live in a high-income household. The third reason is that the Congress was concerned that some high-income taxpayers were shifting assets to their children in an attempt to lower income subject to the parents' higher tax rates. To the extent they shifted that income into lower tax brackets, federal revenue collections were lowered.

[15] While a personal exemption cannot be claimed by a child or student on his or her tax return when a dependency exemption is claimed by a parent, there are some compensating factors. The exemption amount was almost doubled by the passage of the 1986 Act. As such, we could say that the Congress shifted some of the value of the personal exemption from the children/students to the parents. Since the income of the parent is generally larger than the income of the child/student, (placing the parent in a higher tax rate bracket) it follows that the value of a dollar of personal exemption or standard deduction can be higher for the parent than for his or her child/student filing a separate return.

[16] The modification made to the standard deduction of dependents under the Taxpayer Relief Act of 1997 was deemed a simplification measure. The provision was included in the House passed version and remained unchanged when reported by the Senate's Committee on Finance. The Finance Committee's report stated that the reason for change was the belief by the committee ". . . that significant simplification of the existing income tax system can be achieved by providing larger exemptions such that taxpayers with incomes less than the exemption are not required to compute and pay any tax. The committee particularly believes that the present-law exemptions of dependent children are too small." ⁷ This change became effective for tax year 1998.

² The standard deduction amount is adjusted for inflation and will rise to $4,300 for tax year 1999.

³ At the time of enactment, the $700 was the projected inflation adjusted amount for tax year 1998. This amount is adjusted for inflation and may be greater or lesser in future tax years.

⁴ Special tax rules commonly referred to as the "kiddie tax" apply to the unearned investment income of children under the age of 14. These special rules are not covered in this report. For additional information see Minor Children's Income: Effect of the Tax Reform Act of 1986. CRS Report 87-21 A, by Marie B. Morris.

⁵ Internal Revenue Code section 170(b)(1)(A)(ii).

⁶ U.S. Congress. Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986 (H.R 3838, 99th Congress; Public Law 99-514). Washington, G.P.O., 1987. (Joint Committee Print, 99th Congress, 2nd session, no. JCS-10-87)

⁷ U.S. Congress. Senate. Committee on Finance. Revenue Reconciliation Act of 1997 (As Reported by the Committee on Finance) S. 949. Washington, G.P.O., 1997. p. 222. (Report, Senate, 105th Congress, 1st session, no. 105-33)