You can report the child's investment income on your own return in some cases. This is an option if a child's earnings are only from interest and dividends, including capital gain distributions, and are less than $9,000.
In these cases, the child's investment income is detailed on Form 8814, "Parents' Election to Report Child's Interest and Dividends," and included with the parents' tax return. This way, the child doesn't have to file a return of his own. Even when you report the child's income on your return, for the year 2008 the first $900 is still exempt from tax, and the next $900 is taxed at the child's rate. Earnings over $1,800 are then taxed at the parents tax rate.
My guess is that you may not have included the Form 8814 with your return, and because of that, the IRS does not realize that you have already included that $500 on your return. Also, by not including the Form 8814, you would have actually paid tax which you did not need to pay, since the child's first $900 in income is exempt.
If this is the case and you did not file the Form 8814, what you need to do is file an amended return
for the year in question and include the Form 8814 with your amended return. This should also result in a refund being issued for any tax you overpaid as a result of not including the Form 8814 to figure the first $900 as exempt.
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