- Because parents generally have a higher effective tax rate than their children, the parents have an incentive when possible to shift income to a child in order to lower the overall tax burden of the family as a whole.
- Tax law generally prohibits a parent from shifting income from personal services to a child; however, a parent can in some cases effectively shift income to a child by transferring income-producing property to the child.
- The kiddie tax in many cases will prevent a family from gaining a tax benefit from transferring assets from the parents to a child by applying the parents' top tax rate to part of the child's income.
- The imputed interest provisions of Sec. 7872 work to prevent a taxpayer from transferring funds to a child through belowmarket rate loans by imputing interest income to the parent.
- The use of a custodial account or trust to avoid tax on income from property that is used to pay a child's expenses may be thwarted by a parent's legal obligations to support the child.
Parents and grandparents often find themselves with large amounts of appreciated capital wealth. The rates of taxation on long-term capital gains are generally 15% for higher income individuals and 0% (starting in 2008) for lower income individuals. Ordinary income rates range from a low of 10% to a high of 35%. Children and grandchildren generally are subject to the lower ordinary rates, while parents and grandparents are generally subject to the higher rates of ordinary income taxation.
Basic Concepts of Income SplittingIf one can successfully direct the recognition of income away from higher toward lower taxed family members, more after-tax wealth will remain in the overall family unit.
Example 1: Daughter L, age 18, is in the 10% tax bracket on ordinary income and has no investment income. Her father, M, is in the 35% tax bracket and has $200,000 in a money market account earning 5% interest. M would like L to receive and pay tax on the income earned on the $200,000.Focusing only on income taxation (gift taxation with regard to large gratuitous transfers also must be scrutinized by the tax adviser), if an income-splitting plan can be implemented, L would receive and be taxed on the income, and the family's income taxes would be decreased by $2,500 (see Exhibit 1).
Exhibit 1: Tax results of Example 1
|Decrease in M's tax: (.05 × $200,000) × .35 =||($3,500)|
Increase in L's tax: (.05 × $200,000) × .10 =
Decrease in the family's taxes:
Income from Personal ServicesIt is an established principle of federal income taxation that income generated from personal services will be included in the gross income of the person who performs those services. 1 In Lucas v. Earl, Justice Holmes created the famous metaphor to explain that the fruit (income) must be attributed to and taxed to the tree (the earner of that income). An assignment of income does not shift the liability for the tax, even where the earned income was not yet contractually due and payable. 2
Income from Property: A More Flexible RuleUnearned income, such as capital gains, dividends, interest, rentals, and royalties, is derived from property ownership. Unlike personal service income where the fruit (income) cannot be separated from the tree (earner), the income can be split by transferring legal ownership of the underlying property. Subject to the kiddie tax rules (discussed below), if there is a bona fide transfer of ownership in the underlying property, the incidents of taxation can be transferred.
Example 2: Continuing Example 1, M would like L Lto receive and pay tax on the income earned on the $200,000. M can accomplish this at the cost of losing ownership of the $200,000. He can transfer ownership of the money market account to L as a completed gift. L would receive and be taxed on the income and the family's taxes would be decreased by $2,500, as illustrated in Exhibit 1.A transfer to a trust or pursuant to the Uniform Gifts to Minors Act can be disregarded as a sham under the substance-over-form rule if the custodian deals with the property in a way that is factually inconsistent with his or her custodial duties. 3
Where legal ownership of income-producing property is transferred after income from the property has accrued but before the income is recognized to the donor, further analysis is required. The concern here is generally with accrued but unpaid interest income.
InterestInterest income is deemed by IRS revenue ruling and case law 4 to accrue daily. Interest for the period that includes the date of a transfer is allocated between the transferor and the transferee. The transferor must recognize the accrued income at the time it would have been recognized had the transferor continued to own the property.
Example 3: T, a cash basis taxpayer, gave his son, B, bonds with a face value of $10,000 and an 8% stated annual interest rate. The gift was made on January 31, 2007, and B was paid and received the annual interest of $800 on December 31, 2007. T must recognize $68 in interest income (8% × $10,000 × (31 ÷ 365)) for the 31 days before the gift. B will recognize $732 in interest income ($800 – $68).If B did not actually or constructively receive the interest that was payable as of December 31 until January 3, 2008, T , as a cash method taxpayer, would not recognize interest income until the interest was received by B in 2008. T would include the $68 accrued income in his gross income in the 2008 tax year.
DividendsDividends paid on stock do not accrue on a daily basis. The determination to pay a formal dividend is at the discretion of the corporation's board of directors. The board declares that a dividend will be paid to shareholders of record at a stated record date. Regulations 5 state that the record date is the cutoff for determining the shareholders who are entitled to receive the dividend when stock is sold. If a shareholder sells stock after a dividend has been declared but before the record date, the dividend is taxed to the new owner. 6
If a donor gifts stock after the declaration date but before the record date, there is a split in case authority as to who bears the taxable event of the ultimate dividend. The Tax Court 7 has held that the donor/transferor does not shift the dividend income to the donee. The basic logic of the court's holding was that the fruit had sufficiently ripened as of the declaration date to tax the dividend income to the donor. The Fifth Circuit, however, has determined that dividend income, in a case in which the donee was a charitable organization, would be included in the donee's gross income. 8
Example 4: On June 20, the board of directors of J Corp. declares a $1 per share dividend. The dividend is payable on June 30 to shareholders of record on June 25. As of June 20, T owned 200 shares of J stock. On June 21, T sold 100 of the shares to M for their fair market value and gave 100 of the shares to his son B. Assume both M and B are shareholders of record as of June 25. M (the purchaser) will be taxed on the $100 dividend. However, T (the donor) will be taxed on the $100 received by B (the donee) because the gift was made after the June 20 declaration date and before the June 25 record date.
Major Impediments to Income Splitting
The Kiddie TaxPrior to 1987, a parent could readily shift unearned income to a child via a transfer of ownership of income-producing property, as discussed above. The child would pay no tax on income to the extent sheltered by the child's exemption (which was allowable then), and thereafter at the child's lower rate. Sec. 1(g) now generally taxes unearned income of children under age 18 at the parents' highest rate of taxation. More specifically, the age restriction applies to a child who has not attained age 18 before the close of the tax year. In addition, either parent of such a child must be alive at the close of the tax year for the kiddie tax restrictions to be applicable. 9
The Small Business and Work Opportunity Tax Act of 200710 (SBWOTA) significantly expanded the kiddie tax rules going into the 2008 tax year. Amended Sec. 1(g) now not only affects a child who has not yet attained age 18, but many other children under age 24 as well. Under current law, a child who is 18 or is a full-time student aged 19–23 is subject to the kiddie tax rules if the child's earned income does not exceed one-half of his or her support. 11
It is net unearned income that is taxed at the parents' rate. The definition allows a setoff in 2008 of $900 plus the $900 standard deduction for a dependent taxpayer. 12 Thus, in most cases there will be an $1,800 buffer (for 2008) before actual net unearned income generated is subject to the kiddie tax. This amount is adjusted for inflation each year. Thus, a significant amount of unearned income can still be split off to younger children each year as long as legal ownership has been properly conveyed to the child as discussed above.
Example 5: Daughter G, age 13, is subject to tax at a 0% rate on long-term capital gains and has no investment income. P, G's father, is subject to tax at a 15% rate on long-term capital gains. P makes a completed gift to G of zero basis stock. D, G's mother, as custodian for G, sells the stock shortly thereafter, triggering a $1,500 long-term capital gain (see Exhibit 2).Significant state income tax savings would also be typical.
Exhibit 2: Tax results of Example 5
|Decrease in M's tax: ($1,500 × .15) × .35 =||($225)|
Decrease in the family's tax
Imputed Interest on Below- Market Loans, Sec. 7872The below-market loan device has a distinct income-splitting goal.
Example 6: Daughter N, age 22 and not otherwise subject to the kiddie tax, is in the 10% tax bracket on ordinary income and has no investment income. F, her father, is in the 35% tax bracket and has $200,000 in a money market account earning 5% interest. F would like N to receive and pay tax on the income earned on the $200,000. Because F would also like to have access to the $200,000 should he need the money, he does not want to make an outright gift of the money.Before 1984, F could have achieved his goals by lending the money to N in exchange for her $200,000 noninterestbearing note, payable on F's demand. As a result, N would have received and been taxed on the income, and the family's taxes would have been decreased by $2,500.
In essence, Sec. 7872 undoes the income splitting by imputing income to the lender, measured by the difference between interest actually charged on the loan and the government's applicable federal rate. In fact, the below-market loan rules may put the parties in a much worse position than if the loan had never been made. This is accomplished by imputing interest income to the lender, imputing an interest expense deduction to the borrower (which may be deductible as investment interest expense 13 if the borrower is an itemizer), and deeming the lender to have given (possibly subject to gift taxation) the value of the phantom interest deemed paid back to the lender. Thus, if the amount of deemed interest exceeds $12,000 (the annual gift tax exclusion) and/or the borrower is not an itemizer, the parties are generally left in a worse position than if the loan had never been made.
There are two exceptions for such socalled gift loans. One is that no interest is imputed if all outstanding gift loans between individuals are $10,000 or less. However, if the loan proceeds are directly used to purchase income-producing property, this exception is voided, although a second $100,000 exception may be applicable (Sec. 7872(c)(3)).
Under the $100,000 exception, aggregate loans between the borrower and lender must be $100,000 or less. Now the income imputed to the lender is limited to the borrower's net investment income (which is gross income from all investment sources less related expenses). 14 However, if the borrower's net investment income for the year does not exceed $1,000, no interest is imputed to the lender. The $100,000 exception, though, does not apply if the principal purpose of the loan is tax avoidance. 15 The breadth of the interpretation of tax avoidance in Prop. Regs. Sec. 1.7872-4(e) makes this approach a problematic one.
As the above discussion makes clear, earned income cannot be split off from the earner of that income. Unearned income, however, can be manipulated because the income will follow the property's legal owner. However, even after effective transfer of legal ownership, the unearned income now being taxed to the child/owner needs to run the kiddie tax gauntlet.
Nontaxable Uses of Effectively Split IncomeThere is one last major impediment to effective income splitting: What can the children (through their custodian or trustee) use the income for? Sec. 677 provides that trust income used to relieve the trust grantor of a support obligation causes the grantor to be taxed to the extent that the trust income does in fact relieve the taxpayer of his or her support obligation to the person benefitting from the actual distribution. Rev. Rul. 56-48416 and Rev. Rul. 59-35717 work an identical (actually broader) result under Sec. 61 to the extent that property transferred to minors under the Uniform Gifts to Minors Act is used for the benefit of the child in a way that discharges or satisfies a legal obligation of any taxpayer. Although the use of a trust as an income-splitting entity was dealt a blow by the 1993 Revenue Reconciliation Act's18 severe compression of the 35% tax brackets for trusts, trusts can still be a viable tool in the income and estate planners' repertoire. 19
Support ObligationsThis raises the question of what is a support obligation. The cited revenue rulings and regulations and the case law (noted below) state that a support obligation is to be determined under relevant state law. One must then explore parental support obligations under general state law support statutes.
Caution: Many nontax divorce cases have considered a parent's legal obligation of support. Although these cases certainly are relevant to the issue of support under state law, the tax issue examined here could be easily confused because parents have the ability to contractually modify the standard state law support obligation in a divorce and support agreement. Only a relatively few cases have focused directly on the income tax consequences of a parent's legal obligation of support (the issue being examined here).
Because of the wide variation in the state law definitions of what constitutes parental support obligations, this analysis can range across a wide, often strained, definitional realm. For example, what if the dependents have sufficient resources of their own (previously provided by gift from the parents or grandparents) to provide for their own support? Regs. Sec. 1.662(a)-4 states that for the grantor trust rules (and, by analogy, for the custodial analysis), the legal obligation to support a child arises only if the state law obligation is not affected by the adequacy of the child's own resources.
State Decisions on Support ObligationIn Rhode Island, no parental obligation to provide children with private school or college education arises if that expense can be defrayed by the child's own property, income, or corpus of a trust. 20
Conversely, in New Jersey, a grantor was taxed on trust income used to pay his children's expenses in attending private high school and college because such educational responsibilities were found to be within his legal obligation of support. The children's own resources did not affect the parents' support obligation. 21 Although the court in Braun stated that generally parents are not "under a duty to support children after the age of majority," the court went on to hold that "in appropriate circumstances, parental responsibility includes the duty to assure children of a college and even a post-graduate education such as law school." The court strongly insinuated that if there was an expectancy of a college education on both the parents' and the child's part, as well as an ability to pay on the parents' part, a college education would constitute a parental support obligation even when the child had reached the age of majority.
The Braun case could be viewed as an extreme situation. Somewhere between the Rhode Island and New Jersey laws lies a more appropriate answer to what is a support obligation of the parent relative to things such as private high school tuition, college tuition, and other luxury items such as child-owned automobiles.
In the Mairs decision,22 the Eighth Circuit determined that under Minnesota law the father was subject to income tax on amounts expended by trustees for the education of his minor children in college and private high schools. All four children at issue were minors, since the age of majority in Minnesota was then 21. The court indicated that under Minnesota law the support and education requirement of parents was a flexible standard that depended on the family's "position in life" and the parents' financial ability.
In the Morrill decision,23 the court did not determine whether the taxpayer had an obligation under Maine law to educate his minor children. There was a determination that he expressly or impliedly contracted with the relevant schools to provide college and other private school tuition. The father had conceded that he was personally obligated to pay the college expenses because he had expressly assumed that responsibility. In addition, the court noted that an implied contract arises when one renders services to another and the surrounding circumstances make it reasonable for the service provider to believe that payment will be received.
Therefore, the court determined that trust funds expended on the education of his four minor children were taxable to the father. The court noted that the schools' bills were addressed to the taxpayer and not to the trustee or the children. There was no evidence that the schools looked to the children themselves for payment or that the schools were even aware of the existence of the funding trust. Rather, "the institutions sent their bills to Mr. Morrill. Not once did they submit their bills to the trustees or to the children." The court therefore concluded that the schools believed that Mr. Morrill was to be responsible for payment of any bills incurred on behalf of his children.
In the Brooke decision,24 a Montana physician transferred real estate with a building that included a pharmacy, a rental apartment, and the offices of his medical practice to his minor children. At a later point in time, Dr. Brooke was appointed guardian for his children's property. Dr. Brooke made rental payments to himself as guardian for the use of his medical office. Dr. Brooke, as guardian, then used the income to provide the children with insurance; music, swimming, and speaking lessons; private school tuition; an automobile; and travel expenses. At the trial level, the district court recognized that the amounts so expended were not legally required for the support and maintenance of the children. This nonsupport characterization was made despite the fact that Montana law required a parent to provide his or her children with "support and education suitable to his circumstances," which seems to interject a case-by-case subjective criterion.
Under the current Montana statute governing parental support obligations,25 there has been no modification of the Brooke conclusion. Indeed, the annotated statutes cite the Brooke case as authority that the costs of a private high school education, an automobile, musical instruments, or various private lessons are above and beyond the statutory requirements of parental support.
See also Weiss v. Weiss,26 citing to Brooke, where the court distinguished case authority analyzing support in a divorce context from support in the context of an intact family. The Weiss court stated, "There is generally no independent support obligation, beyond the provision of basic necessities. . . . This conclusion . . . embodies the prevailing philosophy that parents should be free, at least in an intact family, to make their own decisions as to how to raise their children, including whether to provide private schools, camps, trips and other luxuries."
In the Wyche decision,27 the grantorfather was not taxable on payments made from a trust fund used for his minor children's private school tuition and music and dancing lessons. The court determined that Wyche had "no legal obligation under South Carolina law to send his children to private day school or to afford them music and dancing lessons." Also, Wyche was careful not to assume any express or implied obligations to make such payments. The schools in question entered into no contracts directly with the parents concerning attendance. Tuition was payable in advance of attendance, and Mrs. Wyche, as trustee, would make the check payable to one of the children, who then endorsed the check for delivery to the school. The school representative receiving the advance payments was advised that they were being made from trust funds and not from the parents' own income.
Timing IssuesAt the time of the Stone decision,28 the California support statute was similar to that of Montana in that it provided that "the father and mother of a child have an equal responsibility to support and educate their child in the manner suitable to the child's circumstances, taking into consideration the respective earnings or earning capacities of the parents." 29 The Stone court, however, specifically cited to the Brooke opinion when noting that the "holdings of other courts with respect to similar obligations under the laws of other states, are of only limited aid here [under California law]."
The court then went on to dismiss the taxpayers' claim that they only had a legal obligation under California law to provide a public school education to their children. The critical factor was that the taxpayers had sent their children to private schools for two or three years prior to the creation of the funding trust. This allowed the court to "assume that, as in Braun . . . , the education that petitioners chose for their children was ‘imminently reasonable in the light of the background values and goals of the parent as well as the children.' . . . They were clearly both willing and able to finance the private high school education of their children."
In the Sharon case,30 the Tax Court again looked at the California support statute in an income tax context. The court did conclude that "college tuition, and clearly luxury items . . . such as European teen tours, are [not] support items. However, whether private high school tuition is a support item is a much closer question." The court then noted that in its Stone decision it had been strongly influenced by the creation of the trust device to specifically provide for and continue the payment of the private high school tuition. In Sharon, however, the court noted that the trust had been in existence since the children were infants and determined that the taxpayer did not transfer "property for the specific purpose of using it to pay [the children's] private high school tuition." Therefore, none of the income was taxed back to the parents.
ConclusionTime will tell if the significant tightening of the kiddie tax rules under SBWOTA will cause the taxing authorities to deemphasize the case law and focus only or primarily on revised Sec. 1(g). Without further guidance, applicable state law will need to be closely scrutinized. If there are no cases analyzing the federal income tax implications of a parent being relieved of a state law support obligation, look at the state case law refining the support obligation in a divorce context.
In a state such as Montana, where the support obligation for luxury items and private school tuition has been well defined, practitioners should be aware of the implied and express contract obligations to pay such items as detailed in the Morrill and Wyche cases. Dovetailing somewhat with the last point are the timing issues raised in the Stone and Sharon cases. The less it looks as if the trust or custodial account was set up to fund specific preexisting obligations, the better it might look to the reviewing court, especially the Tax Court.
Mark Altieri is an associate professor of accounting at Kent State University in Kent, OH, and is special tax counsel to the law firm of Wickens, Herzer, Panza, Cook & Batista in Avon, OH. Linda Zucca is an associate professor of accounting at Kent State University. For more information about this article, please contact Mr. Altieri at mailto:email@example.com.
1 Lucas v. Earl, 281 U.S. 111 (1930).
2 Helvering v. Eubank, 311 U.S. 122 (1940).
3 See, in the context of transfer of S corporation stock, Altieri, "The IRS's Ability to Attack S Corporation Stock Transfers," 28 The Tax Adviser 768 (December 1997).
4 Rev. Rul. 72-312, 1972-1 C.B. 22; Helvering v. Horst, 311 U.S. 112 (1940).
5 Regs. Sec. 1.61-9(c).
7 Anton, 34 T.C. 842 (1960). The Third Circuit reached the same result in Smith Estate, 292 F.2d 478 (3d Cir. 1961). In Rev. Rul. 74-562, 1974 -1 C.B. 28, the IRS ruled in the case of a transfer after both the declaration and record dates but before the payment date, the income was taxable to the donor.
8 Caruth Corp., 865 F.2d 644 (5th Cir. 1989).
9 Sec. 1(g)(2)(B).
10 Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28.
11 The kiddie tax rules now apply to a child who has attained age 18 before the close of the tax year (or is a full-time student aged 19–23) and who meets the following requirements incorporated into Sec. 1(g)(2)(A)(ii): The child meets the age provisions under Sec. 152(c)(3) (the age requirements for a qualifying child under the dependency deduction—the same ages just noted), determined without regard to the rule of Sec. 152(c)(3)(B) (the special rule eliminating any age limit in the case of a permanently and totally disabled dependent); and the child's earned income (generally wages and salaries as defined under Sec. 911(d)(2) or other amounts received as compensation for personal services that have been actually performed) does not exceed one-half the amount of the individual support (within the meaning of Sec. 152(c)(1)(D)) for that tax year. Support is defined the same as it is for purposes of the dependency deduction requirement that a qualifying child not provide more than one-half of his or her own support for the tax year, excluding any scholarships received by a student for study in an educational organization.
12 Or, if greater, allowable itemized deductions directly connected with the production of the unearned income.
13 Sec. 163(d).
14 Sec. 7872(d).
15 Prop. Regs. Sec. 1.7872-4(e): "[T]ax avoidance is a principal purpose of the interest arrangements if a principal factor in the decision to structure the transaction as a below-market loan . . . is to reduce the federal tax liability of the borrower or the lender or both. The purpose of entering into the transaction (for example, to make a gift or to pay compensation) is irrelevant in determining whether a principal purpose of the interest arrangements of the loan is the avoidance of federal tax."
16 Rev. Rul. 56-484, 1956-2 C.B. 23.
17 Rev. Rul. 59-357, 1959-2 C.B. 212.
18 Revenue Reconciliation Act of 1993, P.L. 103-66, §13201.
19 See Pressey, Morrisset, and Nightingale, "The Case for an Intentionally Defective Grantor Trust," on p. 728; Randall and Megaard, "Defective Grantor Trust Can Be Effective Education-Funding Vehicles," 81 J. Tax'n 1950 (1994).
20 RI Gen. Laws §33-15.1-1.
21 Braun, T.C. Memo. 1984-285.
22 Mairs v. Reynolds, 120 F.2d 857 (8th Cir. 1941).
23 Morrill, 228 F. Supp. 734 (D. Me. 1964).
24 Brooke, 468 F.2d 1155 (9th Cir. 1972), aff'g 292 F. Supp. 571 (D. Mont. 1968) and 300 F. Supp. 465 (D. Mont. 1969).
25 MT Rev. Code §40-6-211.
26 Weiss v. Weiss, 1996 WL 91641 (S.D.N.Y. 1996).
27 Wyche, No. 490-71 (Ct. Cl. 1974).
28 Stone, T.C. Memo. 1987-454.
29 CA Civ. Code §196.
30 Sharon, T.C. Memo. 1987-478.