This tax technique is called income shifting and seeks to take
income out of your higher tax bracket and place it in the lowest
(15%) tax bracket of your children. While some tax savings are
available through this approach, the "kiddie tax" rules
impose substantial limitations on it for children under 14.
The kiddie tax rules apply to your children who are under 14
years old, and who have more than a prescribed amount of unearned
(investment) income for the tax year -- $1,400 for 2000.
Essentially, the rules take the investment income of the child
above this amount (called "net unearned income"), and
tax it at the parents' (higher) tax rate. Accordingly, while some
savings (on up to $1,400 of income) can still be enjoyed through
this manner of income shifting, substantial tax savings aren't
available.
The following example shows how the kiddie tax rules work. In
reading through it, note that, under the regular tax rules, a
dependent child cannot claim a personal exemption and is limited
to a standard deduction of $700 in 2000 (unless his "earned"
income, e.g., from a job, plus $250 exceeds that amount).
Example. Mr. and Mrs. Smith are in the 28% federal income tax
bracket. That is, they would pay $28 in additional tax on every $100
of additional income. They have a 12-year-old son, Tommy. They
take a $20,000 bond paying 10% and transfer it to Tommy. Tommy
therefore receives $2,000 of investment income. He has no other
income.
Had the parents kept the bond, they would have paid $560 in tax
on the interest ($2,000 × 28%). Tommy is taxed as follows: His
taxable income is $1,300: $2,000 of gross income reduced by his $700
standard deduction. His "net unearned income" is $600 (the
excess of his interest income above $1,400). This part of his
taxable income is taxed at 28%, for a tax bill of $168 ($600 ×
28%). The rest of Tommy's taxable income, $700 ($1,300 - $600) is
taxed at his 15% tax rate, for a tax bill of $105. Tommy's total
tax is thus $273 ($168 + $105). Since the parents would have paid
$560 on the interest income, the family saves $287 via the tax
move.
If Tommy were 14 or older, all of his taxable income would be
taxed at his own (15%) rate. His tax bill on his $1,300 of
taxable income would then be $195 ($1,300 × 15%), an additional
savings of $92.
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. Thus, in the above example,
the parents were careful to give the child the ownership of the
bond itself and didn't merely assign the income from it to him.
Property can be transferred to minor children using custodial
accounts under the state Uniform Gifts or Transfers to Minors
Acts.
Under the kiddie tax rules, the portion of investment income of
an under-14 child taxed at the parents' tax rates may be reduced
or eliminated if the child's income-producing investments produce
little or no current taxable income. Such investments include:
-Securities and mutual funds oriented toward capital growth which
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.
Under the kiddie tax rules, earned income (as opposed to unearned
investment income), is taxed at the child's tax rates, and never
at the parents', regardless of amount. Therefore, as a means of
providing your child with income, you should consider employing
the child and paying reasonable compensation. This is
particularly appropriate if you have your own trade or business,
but can be done even if you don't.
Where the kiddie tax applies, it's computed and reported on Form
8614, which is attached to the child's Form 1040.
The kiddie tax rules permit parents to 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, if the
election is made, 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.
We hope this information is useful to you. If you would like
futher information, please contact us.