For many years, estate planners have employed various techniques to transfer assets among family members to reduce future estate taxes and current income taxes. By transferring income-producing property to children who have less reportable income (and are thus taxed at lower marginal rates), parents have sought to reduce the taxation of that shifted income. Parents also reduced their own estates through gifts (and reduced the future appreciation of those estates), thereby easing future estate taxes.
In 1986 Congress created the so-called Kiddie Tax, which substitutes the parents’ income tax regime for their child’s under certain circumstances. When the Kiddie Tax was initially enacted, the unearned income of a child under age 14 (to the extent it exceeded $1,500) was taxed to the child at the highest marginal rate of the child’s parents. In 1995 Congress expanded the Kiddie Tax to apply the same tax regime to children under age 18.
On May 25th of this year, the Small Business and Work Opportunity Tax Act of 2007 (PL 110-28, 2007 HR 2206) was enacted which, in part, further expanded the Kiddie Tax. Beginning in 2008, unearned income in excess of $1,700 of either (a) a child under age 19 or (b) a child under age 24 (if the child is a full-time student whose earned income does not exceed onehalf of the child’s support) will be taxed at the highest marginal rate of the child’s parents. Unearned income includes interest, dividends, rent, royalties and capital gains. A child’s earned income, however, will still be taxed at the child’s own rate.
If (i) a child’s gross annual income consists solely of dividends and interest and is less than a stated amount ($8,500 in 2006), (ii) no estimated tax payments (including withholding and overpayments from the prior tax year) were made for the child for the applicable tax year and (iii) the child’s parents meet certain qualifying criteria, the parents may elect to report the child’s income on their tax returns. Otherwise, it is necessary to file a separate return for the child. Electing to report a child’s income on the parents’ returns precludes the parents from taking certain tax deductions that the child could take on the child’s own return. Parents should calculate the tax on their child’s income under both methods to determine which method results in the lower tax.
As a result of the new Act, parents may want to reassess how they manage income-producing investments for their children and make new gifts to them. In order to minimize the Kiddie Tax, parents might consider investments and tax-deferred plans that produce little or no income but are expected to grow in the future for a child under age 19 or a child under age 24 who is a full time student, including, for example, index mutual funds or ETFs and education savings plans.
Of course, current income tax exposure should not drive investment policy in a manner that will forgo growth or lead to illiquid or costly investments for the child.
If your child under age 19 or under age 24 who is a full-time student receives unearned income or if you are planning on transferring income-producing investments to the child, we suggest that you contact your attorney or accountant to discuss ways to report, eliminate or minimize the impact of the Kiddie Tax.