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The "Kiddie Tax" Rules

How can you save taxes by transferring assets into your children's names?

This tax technique is called income shifting. It seeks to take income out of your higher tax bracket and place it in the lower tax brackets of your children (as low as 10%). While some tax savings are available through this approach, the "kiddie tax" rules impose substantial limitations on it for children under 18.

The kiddie tax rules apply to your children who are under 18 years old, and who have more than a prescribed amount of unearned (investment) income for the tax year—$1,700 for 2006 and 2007. Essentially, the rules take the investment income of the child above this amount (called "net unearned income"), and tax it at the parents' (higher) tax rate. Accordingly, while some savings on up to $1,700 of income for 2006 and 2007 can still be enjoyed by income shifting to children under 18, substantial tax savings aren't available.

The following example shows how the kiddie tax rules work. In reading through it, note that, under the regular tax rules, a dependent child cannot claim a personal exemption and is limited to a standard deduction of $850 in 2006 and 2007 (unless his "earned" income, e.g., from a job, plus $300, exceeds that amount).

Example. For 2007, Mr. and Mrs. Smith are in the 25% federal income tax bracket. That is, they would pay $25 in additional tax on every $100 of additional income. The couple are the parents of a 12-year-old son, Tommy, to whom they transfer a $20,000 bond that pays 10%. Tommy therefore receives $2,000 of investment income. He has no other income.

Had the parents kept the bond, they would have paid $500 in tax on the interest ($2,000 × 25%). Tommy, instead, is taxed on $1,150 of taxable income—$2,000 of gross income reduced by his $850 standard deduction—as follows. His "net unearned income" is $300 (the excess of his interest income above $1,700). This part of his taxable income is taxed at 25%, for a tax of $75 ($300 × 25%). The rest of Tommy's taxable income, $850 ($1,150 − $300) is taxed at his 10% tax rate, for a tax of $85. Tommy's total tax is thus $160 ($75 + $85). Since the parents would have paid $500 on the interest income, the family saves $340 via the tax move.

If Tommy were 18 or older, all of his taxable income would be taxed at his own 10% rate. His tax bill on his $1,150 of taxable income would then be $115 ($1,150 × 10%), an additional savings of $45.

Note that, to transfer income to a child, you must actually transfer ownership of the asset producing the income: you cannot merely transfer the income itself. Thus, in the above example, the parents were careful to give the child the ownership of the bond itself and didn't merely assign the income from it to him. Property can be transferred to minor children using custodial accounts under the state Uniform Gifts or Transfers to Minors Acts.

The portion of investment income of an under-18-year-old child that is taxed at the parents' tax rates under the kiddie tax rules may be reduced or eliminated if the child's income-producing investments produce little or no current taxable income. Such investments include:

  • securities and mutual funds oriented toward capital growth which produce little or no current income;
  • vacant land expected to appreciate in value;
  • stock in a closely-held family business, expected to become more valuable as the family business expands, but which pays little or no cash dividends;
  • tax-exempt municipal bonds and bond funds;
  • U.S. Series EE bonds, for which recognition of income can be deferred until the bonds mature, the bonds are cashed in, or an election to recognize income annually is made.

Investments that produce no taxable income—and which are therefore not subject to the kiddie tax—also include tax-advantaged savings vehicles such as:

  • traditional and Roth individual retirement accounts (IRAs and Roth IRAs, which can be established or contributed to if the child has earned income);
  • qualified tuition programs (QTPs, also known as 529 plans); and
  • Coverdell education savings accounts.

A child's earned income (as opposed to unearned investment income) is taxed at the child's tax rates, and never at the parents', regardless of amount. Therefore, as a means of saving taxes within the family, you should consider employing the child and paying reasonable compensation. This is particularly appropriate if you have your own trade or business, but can be done even if you don't.

Where the kiddie tax applies, it's computed and reported on Form 8615, which is attached to the child's Form 1040.

The kiddie tax rules permit parents to elect to include the child's income on their own return, if certain requirements are satisfied. This avoids the need for a separate return for the child, but, generally, doesn't change the tax on the child's unearned income, which is still taxed at the parents' tax rate. However, it's important to consider whenever this election is made that the addition of the child's income to the parent's adjusted gross income may affect the various floors and ceilings for, and therefore the amounts of, the parents' deductions and limitations.

The election to include a child's income on the parents' return is made, and the additional taxes resulting to the parents are computed and reported, on Form 8814.

 

 
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