The 'kiddie' tax rules attempt to curtail a strategy that some wealthy and moderate-income parents use to lower taxes by transferring income-producing assets to their children. And with the current shift in tax law, this strategy would have been even more appealing. So this past spring, with a stroke of his pen on May 25, President Bush signed into law the Small Business and Work Opportunity Tax Act of 2007 (SBA), which included an expansion of the kiddie tax.
Here's why: The top tax rate in 2007 on 'adjusted net capital gain,' which includes most long-term capital gains and corporate dividends, is 15 percent. But to the extent a taxpayer's adjusted net capital gain would otherwise be taxed in the two lowest tax brackets'the 10 percent and 15 percent brackets'it's taxed at 5 percent for 2007, and 0 percent for 2008 through 2010.
Some families sought to benefit from these rates by gifting appreciated stock, mutual-fund shares and other securities to their low-income, young-adult children who, if no longer subject to the kiddie tax rules (see box) and in one of the two lowest tax brackets, could then sell the securities tax-free in 2008, 2009 and/or 2010. The changes in the law, however, will eliminate the opportunity to do this in many cases.
Broadened kiddie tax For tax years after May 25, 2007, the SBA does not change the kiddie tax rules for children under 18 (see box), but expands it to apply where:
- the child turns age 18, or turns age 19-23 if a full-time student, before the close of the tax year
- the child's earned income for the tax year doesn't exceed one-half of his support
- the child has more than the inflation-adjusted prescribed amount of unearned income (i.e., $1,700, indexed for inflation annually)
- the child has at least one living parent at the close of the tax year
- the child doesn't file a joint return for the tax year
Prior “Kiddie” Tax Rules
A child is subject to the kiddie tax if:
The child then pays tax at his parents’ highest marginal rate, or the parents can elect to include on their own return (on form 8814) the child’s gross income in excess of $1,700 (for 2007).
Because of the nature of these changes, transfers of income-generating investments to children who are age 18, or those age 19-23 who are full-time students, must be reconsidered.
One way of providing a child with income without triggering increased tax liability under the kiddie tax rules is to employ the child in a trade or business the parent owns, assuming the wages are reasonable for the work performed. Earned income is always taxed at the child's tax rates.
Investing a child's funds in investments that produce little or no current taxable income can also help avoid the kiddie tax. These investments may include growth stocks and mutual funds, vacant land expected to appreciate in value, stock in a closely-held family business, tax-exempt municipal bonds and bond funds, and U.S. series EE savings bonds for which interest reporting may be deferred.
Investments not subject to the kiddie tax also include tax-advantaged savings vehicles, such as traditional and Roth IRAs (which can be established or contributed to if the child has earned income), qualified tuition programs (529 plans) and Coverdell education savings accounts (CESAs). However, caution should be taken since assets in a child's name can have a negative impact on the student's eligibility for college financial aid.
Glenn E. Stevick Jr., CLU, ChFC, LUTCF, a member of Tri-County AIFA (N.J.), is an LUTC author and editor, and assistant professor of insurance at The American College. Contact him at Glenn.Stevick@TheAmericanCxollege.edu.