Earned income includes wages, tips, contract service income, self-employment net income, and other payments for personal services performed. Unearned income is generally investment income—e.g., interest, dividends, capital gains, rent, royalty, Social Security, and beneficiary distributions.
In 2006, the kiddie tax applied if the following conditions were met:
- The child’s unearned income exceeded twice the child’s standard deduction of $850 (i.e., $1,700);
- The child was under age 18 at the end of the year;
- One of the child’s parents was alive at the end of the year;
- The child was required to file a tax return; and
- The child did not file a joint return.
Age Group ExpandedThe Small Business and Work Opportunity Tax Act of 2007, P. L. 110-28, did not change the basics of the kiddie tax, but broadened its application to include more children. The kiddie tax historically covered children who were of an age that they would still be at home and under parental influence. Now the tax includes the age group that has moved out of the house and is learning to make independent decisions but still needs some parental support to survive. The updated kiddie tax criteria now extend to all children under 19 with the above-stated conditions. The kiddie tax now also applies to a child aged 19–23 if:
- The child is a full-time student before the close of the tax year; and
- The child’s earned income does not exceed one-half of his or her support.
There are a few
obvious effects from this change. Children and college students
from middle-class and wealthy families will owe more taxes due to
exposure to their parents’ higher rates. Children who generate
savings and investments independent of their parents may now need
to consult with them on their tax-filing requirements. The
advantages to parents from shifting investments that generate
current-year income to their lower-tax-bracket children diminish.
Gifts of investments may need to be restructured.
The potentially bigger fallout is the effect from the capital gains rates for the lowest income brackets in 2007 and 2008. For those in the lowest tax brackets, the capital gains rate is 5% in 2007 and 0% in 2008; it is 15% for higher brackets. Many individuals may have shifted appreciated assets to the children in expectation of selling the assets in 2008 and benefiting from the 0% tax rate on the net gain on the child’s side. The expansion of the kiddie tax essentially eliminates these rates for any families trying to shift capital gains to the child’s lower tax bracket.
New Strategies and AlternativesThe kiddie tax changes are effective for tax years after May 25, 2007. For most taxpayers, this will affect their 2008 tax filings. So now is the time to consider new strategies and alternatives:
- Earned income is not taxed at the parents’ rate. Even if the child has unearned income subject to the kiddie tax, any earned income will still be taxed at the child’s own rates (which are usually lower). Under Sec. 152(c)(1)(D), earned income can also help with the support test that exempts the child from the kiddie tax. Children who earn enough income to cover half of their support are not subject to the kiddie tax (and the parents cannot take a dependency deduction).
- The child is employed in the family business. This expands on the previous point. The income to a child employed in the family business is earned income and helps with the support test. The wages create ordinary deductions for the family business and could reduce dividend payouts. Self-employed individuals can employ their child under age 18 and do not have to pay FICA (Sec. 3121(b)(3)(A)); if the child is under 21, they do not have to pay FUTA taxes (Sec. 3306(c)(5)). In a partnership, the parents must be the only partners in order to reap the same employment tax benefits (Regs. Sec. 31.3121(b)(3)-1(c)). Of course, any compensation must be for legitimate work and at a reasonable wage.
- Sell investments in 2007 instead of 2008. If the intent of the individual was to benefit from the low capital gains rates over the next two years, they may want to sell the appreciated stock or mutual fund holdings before the end of the year. If sold in 2007, the child’s capital gains rates (typically 5%) will apply instead of the parents’ rates (15%).
- Invest and/or move investments to vehicles that generate capital growth over income-producing property. Consider investments in high-growth, low-dividend stocks and funds, stocks in a closely held business, tax-exempt municipal bonds, U.S. series EE savings bonds (interest is deferred until the bond is cashed in), and vacant land expected to appreciate. Be careful when dealing with vacant land if incidental sublease income should be incurred, as this is unearned income subject to the kiddie tax.
- Consider contributing to investments that do not generate taxable income. Contribute to a traditional or a Roth IRA. The child must have earned income in order to make the contribution. Children may also get a deduction for the IRA to the extent of their earnings (as long as they are not covered under another retirement plan), so their taxable income can be lowered. Coverdell education savings accounts (Sec. 530) and qualified tuition programs (Sec. 529) allow investment income to be tax exempt, and children pay no tax when they withdraw from the accounts for their education.
- Hold off on shifting income-generating investments until the child reaches age 24. Individuals moving stocks that generate dividends could consider whether the dividend income creates enough unearned income to trigger the kiddie tax. If the individual is trying to transfer gifts to a child, his or her portfolio should be reviewed for investments that meet point 4 above and do not generate current-year payouts that are income.
If children are under age 24 on December 31, 2007, it would be wise to readdress their investment portfolios. Until the student child turns 24, parents need to be aware of their child’s unearned and earned income to determine the support test for the kiddie tax. Parents may need to consider employing children in the family business, reviewing their gifting strategy, and investing in IRAs and education savings programs in which withdrawals are tax free and benefit the student.
Joel E. Ackerman, CPA, MST is with Holtz Rubenstein Reminick LLP, DFK International/USA Melville, NY.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.
If you would like additional information about these items, contact Mr. Ackerman at (631) 752-7400 x262 or firstname.lastname@example.org.