Planning for the Kiddie Tax

Overview and Recent Changes to the Kiddie Tax

The so-called “kiddie tax” was created to discourage parents from shifting income-producing assets (e.g., stocks, bonds, mutual funds, etc.) to their children in an effort to take advantage of their children’s lower income tax brackets. Under the kiddie tax, the unearned income of young children is taxed at the parents’ highest marginal tax rate. The kiddie tax applies only to the extent a child’s unearned income exceeds an inflation-adjusted amount ($1,700 for 2007 and $1,800 in 2008), and only if it results in a higher tax. Any unearned income below the $1,700 threshold is taxed at the child’s rate. To the extent a child has income from a job (i.e., earned income), the kiddie tax does not apply.

Recently, Congress has been tinkering with the kiddie tax rules. Prior to 2006, the kiddie tax only applied to children under the age of 14, but the Tax Increase Prevention and Reconciliation Act of 2005 expanded its application to older teens, beginning in 2006. After this change, the kiddie tax applies to a child who meets the following criteria:

1) he or she has not turned age 18 by the end of the year
2) he or she has more than $1,700 of unearned income for the year (in 2007)
3) he or she has at least one living parent at the close of the year
4) he or she does not file a joint income tax return for the year

As part of the Small Business and Work Opportunity Act of 2007, the application of the kiddie tax rules was expanded again. Beginning in 2008, the kiddie tax continues to apply to children under the age of 18 (as described above), but it also applies to a child who meets all of the following criteria:

1) he or she turns age 18 (or, if a full time student, turns age 19-23) by the end of the year
2) he or she has more than the inflation-adjusted amount of unearned income (currently, $1,700 and $1,800 in 2008) for the year
3) he or she has at least one living parent at the close of the year
4) he or she does not file a joint income tax return for the year
5) his or her earned income for the year does not exceed one-half of his or her support

One of the motivations for this latest change to the kiddie tax rules was to prevent parents from using their children to take advantage of the favorable tax rates applicable to long-term capital gains and qualified dividends that begin next year. In 2008 through 2010, taxpayers in the two lowest income tax brackets (10 percent and 15 percent) will be taxed at 0 percent on long-term capital gains and qualified dividends. Consequently, if a child was not subject to the kiddie tax rules, then a parent could transfer appreciated stock or mutual fund shares to him or her, and that child could sell them tax free in 2008, 2009 and/or 2010.

By expanding the kiddie tax rules to apply to 18-year-old children and full-time students up to age 23, Congress sought to partially close this perceived loophole. It is important to note that for 2007, before the latest change to the kiddie tax rules goes into effect, taxpayers in the two lowest tax brackets are taxed at 5 percent on long-term capital gains and qualified dividends. As a result, parents can still take advantage of the tax rate disparity as long as their child is at least age 18 in 2007.

Planning Ideas

An individual may make annual gifts of up to $12,000 (in 2007 and 2008) per recipient without triggering any gift tax consequences. Such gifts are often referred to as annual exclusion gifts. Gifts beyond the $12,000 annual exclusion limit require the use of the individual’s $1,000,000 lifetime gift tax exemption. As part of a prudent estate plan, parents often take advantage of both annual exclusion gifts and their lifetime gift tax exemption to shift assets to their children, but the expanded application of the kiddie tax rules may discourage many parents from doing so (at least with respect to their younger children).

A popular vehicle for making such gifts has been the Uniform Transfers to Minors Act (or Uniform Gifts to Minors Act) custodial accounts. Because the assets contained in these accounts are taxable to the child and, therefore, subject to the kiddie tax rules, parents may wish to curtail further funding of any custodial accounts. However, since the kiddie tax does not apply until unearned income exceeds a certain inflation-adjusted amount (i.e., $1,700 in 2007), it is possible to minimize its application by choosing growth-oriented investments (e.g., non-dividend paying stocks), rather than high income producing investments (e.g., taxable bonds).

There are certain tax-advantaged savings vehicles designed to provide for educational expenses that could be used for making gifts to young children while avoiding the kiddie tax. These tax-advantaged savings vehicles include 529 college savings plans, Coverdell education savings accounts and prepaid college tuition programs offered by many states. Because the assets contained in these vehicles are not subject to income tax if they are used to pay for higher education expenses, they are not subject to the kiddie tax either.

Another possible way to shift assets to a child while avoiding the kiddie tax would be to hire the child in the family business, or simply hire the child to perform household chores (e.g., lawn care). The idea is to produce earned income (rather than unearned income) for the child. Obviously, if the earned income is then invested, it may produce unearned income, but all or a portion of that earned income could be contributed to a tax-advantaged retirement account (e.g., Roth IRA or traditional IRA) by the child. Because the assets contained in such retirement accounts are not subject to income tax unless withdrawn, they are not subject to the kiddie tax either.

Another option is to create an irrevocable trust for the benefit of a child. If the trust is designed to be a separate taxpayer (known as a “non-grantor trust”), then it could have income as high as $10,450 (for 2007) before the trust’s income is taxed at the highest income tax rate of 35 percent. Income earned by the trust that isn’t distributed to the child would not be subject to the kiddie tax.

Obviously, for parents who are subject to the top income tax rate, this option yields a much better result than having to pay a 35 percent income tax when a child’s unearned income reaches $1,700 (in 2007). In addition, distributions of income could be made to the child from the trust to reduce the income tax liability of the trust and take advantage of the child’s lower income tax bracket. Of course, for younger children, these distributions of income from the trust would be subject to the kiddie tax if they caused the child to exceed the unearned income limit.

One variation of the trust option described above is to make the irrevocable trust a “grantor trust,” which means that the parent who created the trust must pay any income tax generated by the trust assets. If one assumes most of the trust’s income is going to be subject to the top income tax rate under the kiddie tax rules, the child’s parents will pay that income tax liability out of non-trust assets which will allow more assets to remain in the trust to grow for the benefit of the child. In other words, the trust assets will not be depleted by any income tax liability, because the child’s parents bear that burden.

Conclusion

In addition to the planning ideas discussed above, parents should remember that once a child reaches age 19 (if not a full-time student), or age 24 (if a full-time student), even the newly-expanded kiddie tax rules will no longer apply. In other words, the kiddie tax is a temporary impediment to a parent’s gift giving program, and with proper planning, its impact can be minimized.