Parents in high income tax brackets have long tried to shift unearned income such as interest and dividends to children in lower brackets to achieve overall income tax savings for the family. Congress fi rst sought to curtail this perceived abuse in 1986 by passing a law commonly known as the “kiddie tax.” Under the kiddie tax, the federal income tax on a child’s net unearned income (unearned income in excess of an infl ation-adjusted amount) is determined as if such income were earned by the child’s parents, if this results in a higher federal income tax. The recently enacted Small Business and Work Opportunity Tax Act of 2007 extends the reach of this tax to older children and certain children who are full-time students.
The prior version of the kiddie tax provided that a child’s unearned income in excess of $1,700 (adjusted for infl ation) was taxed at the parents’ tax rate if the child (1) had not reached age 18 by the end of the tax year, (2) had at least one parent living at the end of the tax year and (3) did not fi le a joint tax return. For tax years beginning after May 25, 2007 (for most people, this means 2008 and subsequent years), the kiddie tax applies to a child who has not reached age 19 by the end of the calendar year in which the tax year of the parents begins. More signifi cantly, the kiddie tax now also applies to a child who has not reached age 24 by the end of such calendar year if the child is a full-time student and does not provide more than one-half of his or her own support from his or her own earned income. The rules relating to the unearned income threshold, living parents and joint tax returns remain unchanged.
Parents seeking to avoid the consequences of the amended kiddie tax may wish to consider alternative investment strategies. For example, parents contemplating the transfer of investments to children who are subject to the kiddie tax may want to consider investments that produce long-term capital gains or investments that generate little or no current taxable income, such as taxexempt municipal bonds, unimproved land, or stocks or mutual funds that pay few, if any, dividends.
If a child holds investments and exceeds the age threshold this year, but will be subject to the kiddie tax when the new age limits go into effect for 2008, he or she may want to consider selling assets that have been held for more than one year to take advantage of the low federal income tax rate (as low as 5 percent) on long-term capital gains in 2007. You can even give such a child appreciated investments to sell in 2007, so gain will be taxed at the lower rate. However, beware of the federal gift tax consequences if you do this. Parents also may want to consider a section 529 plan if the child plans to attend college. Investment income on assets in a section 529 plan is not subject to federal income tax, including the kiddie tax.