Wondering how you can save taxes by transferring assets
into your children's names?
This tax technique is called income shifting. It
seeks to take income out of your higher tax bracket and place it in the lower
tax brackets of your children. While some tax savings are available through
this approach, the "kiddie tax" rules impose substantial limitations
on it if:
1.
the child
hasn't reached age 18 before the close of the tax year, or
2.
the
child's earned income doesn't exceed one-half of his support and the child is
age 18 or is a full-time student age 19 to 23.
The kiddie tax rules apply to your children who are
under the above-described cutoff age, and who have more than a set amount of
unearned (investment) income for the tax year-$2,100 for 2016 or 2015.
Essentially, these rules tax the child's investment income above this amount
(called "net unearned income") at the parents' (higher) tax rate.
While some tax savings on up to $2,100 of income for 2016 or 2015 can still be
achieved by shifting income to children under the cutoff age, the savings
aren't substantial.
The following example shows how the kiddie tax rules
work. Note that, under the regular tax rules, for 2016 a dependent child cannot
claim a personal exemption and is limited to a standard deduction of $1,050
(unless his "earned" income, e.g., from a job, plus $350, exceeds
that amount).
Example. For 2016, Mr. and Mrs. Smith are in the 25% federal
income tax bracket. That is, they would pay $25 in additional tax on every $100
of additional income. The couple are the parents of a 12-year-old son, Tommy,
to whom they transfer a $22,000 bond that pays 10%. Tommy therefore receives
$2,200 of investment income. He has no other income.
Had the parents kept the bond, they would have paid
$550 in tax on the interest ($2,200 × 25%). Tommy, instead, is taxed on $1,150
of taxable income-$2,200 of gross income reduced by his $1,050 standard
deduction-as follows. His "net unearned income" is $100 (the excess
of his interest income above $2,100). This part of his taxable income is taxed
at 25%, for a tax of $25 ($100 × 25%). The rest of Tommy's taxable income,
$1,050 ($1,150 − $100) is taxed at his 10% tax rate, for a tax of $105. Tommy's
total tax is thus $130 ($25 + $105). Since the parents would have paid $525 on
the interest income, the family saves $420 via the tax move.
If Tommy were 19 or older or, if a student, 24 or
older, all of his taxable income would be taxed at his own 10% rate. His tax
bill on his $1,150 of taxable income would be $115 ($1,150 × 10%). An
additional savings of $15.
Note that, to transfer income to a child, you must
actually transfer ownership of the asset producing the income: you cannot
merely transfer the income itself. In the above example, the parents were
careful to give the child the ownership of the bond itself and didn't merely
assign the interest payments to him. Property can be transferred to minor
children using custodial accounts under the state Uniform Gifts or Transfers to
Minors Acts.
The portion of investment income of a child that is
taxed at the parents' tax rates under the kiddie tax rules may be reduced or
eliminated if the child's investments produce little or no current taxable
income. Such investments include:
·
securities
and mutual funds oriented toward capital growth that produce little or no
current income;
·
vacant
land expected to appreciate in value;
·
stock in
a closely-held family business, expected to become more valuable as the family
business expands, but which pays little or no cash dividends;
·
tax-exempt
municipal bonds and bond funds;
·
U.S.
Series EE bonds, for which recognition of income can be deferred until the
bonds mature, the bonds are cashed in, or an election to recognize income
annually is made.
Investments that produce no taxable income-and which
are therefore not subject to the kiddie tax-also include tax-advantaged savings
vehicles such as:
·
traditional
and Roth individual retirement accounts (IRAs and Roth IRAs), which can be
established or contributed to if the child has earned income;
·
qualified
tuition programs (QTPs, also known as "529 plans"); and
·
Coverdell
education savings accounts ("CESAs").
A child's earned income (as opposed to investment
income) is taxed at the child's (not the parents') tax rates, regardless of
amount. Therefore, to save taxes within the family, consider employing the
child and paying reasonable compensation. This is particularly appropriate if
you have your own business, but can be done even if you don't.
Where the kiddie tax applies, it's computed and
reported on Form 8615, which is attached to the child's Form 1040.
Parents can elect to include the child's income on
their own return, if certain requirements are satisfied. This avoids the need
for a separate return for the child, but, generally, doesn't change the tax on
the child's unearned income, which is still taxed at the parents' tax rate.
However, it's important to consider that the addition of the child's income to
the parent's adjusted gross income may affect the various floors and ceilings
for, and therefore the amounts of, the parents' deductions and limitations.
The election to include a child's income on the
parents' return is made, and the additional taxes resulting to the parents are
computed and reported, on Form 8814.
If you have any questions on the kiddie tax or would like to discuss the tax ramifications of transferring assets into your children’s names, please contact us.
