June 11, 2007

They say the best laid plans... Ian intended to fund his son Max's college education, at least in part, by gifting appreciated stock and mutual fund shares to Max. 

Max will fall into the 10 or 15 percent tax brackets during his college years. That means he can sell the gifted stock and take advantage of the significantly lower federal tax rate on capital gains that is available to lower-income taxpayers through 2010. Given Max's tax bracket, his capital gains tax rate is only five percent tax for 2007 and zero percent for 2008, 2009 and 2010. These rates are considerably less than the 15 percent rate that Max's higher-income father will pay if Ian sells the shares himself.  

Under Ian's plan, the federal kiddie tax was not an issue. Max starts his freshman year at the university this fall and he turns 18 in December, so he's past the age the kiddie tax applies. Or he was. Last month, Congress expanded the reach of the kiddie tax and ruined Ian's plan, along with many of the income-shifting or tax-reducing strategies of other moderate-income and affluent parents. 

The kiddie tax refers to federal income tax rules that require a child's unearned (investment) income--including interest, dividends, and capital gains--to be taxable at the parent's higher marginal federal tax rate, if age requirements and certain other criteria are met. Congress enacted the kiddie tax to discourage shifting income-earning assets from higher-tax-bracket parents to lower-tax-bracket children. Earned income is not subject to the kiddie tax. 

Last month, the scope of the kiddie tax was once again expanded under the Small Business and Work Opportunity Tax Act of 2007 in order to enhance revenues for the federal government. Congress estimates that the expanded kiddie tax will raise something like $1.4 billion over the next decade. The legislation represents the second time the kiddie tax was expanded in little more than a year.

The changes to the kiddie tax rules are effective for tax years beginning after the date the legislation was signed into law--May 25, 2007. For calendar-year taxpayers, this means the new rules are effective in 2008, destroying many of the income-shifting and tax-saving strategies of moderate-income and affluent parents.

Kiddie Tax Rules for 2007
Under pre-existing rules, a child is potentially subject to the kiddie tax during any tax year for which all of the following criteria are met:

  The child has not reached the age of 18 before the end of the tax year. 

  At least one parent is alive as of the end of the tax year.

  The child does not file a joint return for the tax year. 

For a child subject to the kiddie tax, unearned income above a specified minimum amount is taxed at the parents' highest marginal rate--as long as that tax is higher than the tax the child would otherwise pay. For 2007, the minimum unearned income amount is $1,700. 

As an alternative in certain situations, parents can choose to include their children's unearned income in excess of $1,700 per child on their own federal tax return. 

Kiddie Tax Rules for 2008 and After
Under the new law, the kiddie tax rules do not change for children who are under age 18. For calendar 2008 and beyond, they do, however, extend the reach of the kiddie tax to children that meet all of the following criteria: 

  The child reaches the age of 18 before the end of the tax year--or reaches the age of 19 through 23 by the end of the year and is a full-time student.

  The child's earned income for the tax year is not more than one-half of the child's support.

  The child has more than the inflation-adjusted maximum amount of unearned income for the tax year--$1,700 for 2007.

  At least one parent is alive as of the end of the tax year. 

  The child does not file a joint return for the tax year.

Strategies to Avoid the Kiddie Tax
If you think the expanded kiddie tax might apply to your child, a little planning now can help you to minimize the risk. Central to kiddie-tax-avoiding strategies for many children--specifically those who reach 18 by the end of the tax year or reach age 19–23 and are full-time students--is the fact that the child is only subject to the kiddie tax if his or her earned income in any tax year represents no more than half of the total support. 

The kiddie tax does not apply to earned income. In fact, earned income--to the extent it reduces the support needed--may even exempt the child from paying kiddie tax on unearned income. Thus, one way of providing funds to your child without triggering the kiddie tax, or sheltering you child's investment income from the kiddie tax, is to legitimately employ him or her in the family business. If that's not possible, seek other employment opportunities. 

Not all investments earn taxable income--for example, certain appreciating real estate, growth funds, stocks that don't traditionally pay dividends, tax-exempt municipal bonds, certain savings bonds, 529 tuition plans, education savings accounts, and IRAs. By investing your child's funds in vehicles that produce little or no current taxable income--or shifting to such investment vehicles--you reduce unearned income, and therefore the likelihood of triggering the kiddie tax.*

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* Note that income from a trust for which your child is a beneficiary may be subject to the kiddie tax, depending on the trust. 

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