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Kiddie Tax Planning

New Law
Means Higher Taxes For Some

Years ago, Congress came up with the concept known as the Kiddie Tax. It was intended to discourage high-tax-bracket parents and grandparents from shifting taxable income (especially from investments) to

Tax-Free Gains May Not Be Possible,
But if You Act Fast,
Your Family Might Be Able to Pay Just 5 Percent Tax

    Based on tax rules that are scheduled to kick in next year, some parents and grandparents in high tax brackets were planning to give older teens appreciated assets they had held for more than a year.
    The youngsters could then sell the assets in 2008 and pay no federal capital gains tax, while their higher bracket parents and grandparents would have to pay 15 percent. That's because the capital gains rate will drop to zero percent in 2008 for taxpayers in the lowest two tax brackets.
    Unfortunately, the new law passed last month has eliminated that opportunity in many cases under new Kiddie Tax provisions that become effective in 2008.
   So if you act fast, there still might be a way to pay only the current 5 percent capital gains tax on gifts to children who will be age 18 and older on 12/31/07.
    You can give each of them up to $12,000 worth of appreciated securities this year without any gift or estate tax consequences. If you're married, your spouse can give away $12,000 to each child too.
    The recipients can then sell the appreciated securities before the end of 2007 and pay only 5 percent capital gains tax, if they are in the 10 or 15 percent tax brackets. The sales proceeds can be used to cover college or other expenses. For this to work, however, you and the gift recipient must have a combined ownership period of more than one year.

All Income is Not Affected

     The Kiddie Tax Only Hits Unearned Income, typically from investments held in the child's name. Earned income from jobs or self-employment is exempt from the Kiddie Tax.
     It Only Hits Unearned Income above an Annual Threshold. For 2008, the amount will be at least $1,700. It may be higher due to an inflation adjustment.

lower-bracket children in order to reduce the family's income tax bill.

Since its inception, many affluent families planned to save money in ways to avoid the Kiddie Tax. Unfortunately, Congress has pulled the rug out from under these families. Under a new law, the Kiddie Tax will soon apply to older children -- in fact, to young adults.

In this article, we'll explain the current rules and how they will change under the Small Business and Work Opportunity Tax Act of 2007, which was signed into law on May 25th.

The Basics. Let's say you're in the 35 percent federal tax bracket and want to shift assets to your children or grandchildren. You figure they can invest in income-producing investments like dividend-paying stocks, T-Bills and mutual fund shares. Then, the kids could pay taxes on the resulting investment income at a much lower federal tax rates. Sadly, the Kiddie Tax rules are intended to stymie this tax-saving goal.

Child's Age Is the Key Factor

In just over a year, Congress has changed the Kiddie Tax rules twice. Here is a rundown of the situation:

  • Before 2006, the Kiddie Tax only applied to years when the child was under age 14 at the end of the year.
  • For tax years 2006 and 2007, the Tax Increase Prevention and Reconciliation Act (enacted in 2006) changed the age to 18. So if your child is age 18 or older at the end of this year, the Kiddie Tax does not apply for 2007.
  • For tax years beginning in 2008 and beyond (for calendar-year individuals), the Small Business and Work Opportunity Tax Act changed the age again. In these years, the Kiddie Tax can potentially come into play until the year during which your child turns 24. In other words, only when the child is 24 or older at year end can you say with certainty that the Kiddie Tax will not apply for 2008 and subsequent years.

Current Rules

If your child is under age 18 as of the end of 2007, some of his or her unearned income from investments might be taxed at your higher marginal federal rate. The Kiddie Tax is an issue for 2007 (and 2006) only when all of the following requirements are met:

Requirement 1: One or both of the child's parents are alive at year end and in a higher marginal federal income tax bracket than the child.

Requirement 2: The child doesn't file a joint tax return for the year.

Requirement 3: The child's unearned income for the year exceeds the threshold for the year. The threshold for 2007 (and 2006) is $1,700. If the threshold is not exceeded, the Kiddie Tax simply doesn't apply for that year. If the threshold is exceeded, only unearned income in excess of the threshold amount is hit with the Kiddie Tax.

Requirement 4: The child has not reached age 18 at year end (in other words, he is age 17 or younger on December 31).

As you can see, the Kiddie Tax rules do not take into account whether or not the child is claimed as a dependent by a parent or by someone else.

Example: Let's say your son will be age 17 on 12/31/07. For 2007, he is subject to the Kiddie tax if all of the other three requirements are also met for the year. Your daughter will be age 18 on 12/31/07. For 2007, she is exempt from the Kiddie Tax because she reaches the magic age of 18 by year end.

But what about 2008 and beyond? Good question, because the stricter rules apply for those years.

How Your Family Could Be Affected Next Year

For 2008 and later years, the Kiddie Tax is an issue when certain requirements are met. As in the past, one or both of the child's parents must be alive at year end and in a higher marginal federal tax bracket than the child.

The Kiddie Tax still does not apply to a married child who files a joint return. And a child can still earn taxable investment income up to an inflation-adjusted threshold for the year (currently $1,700) without being taxed at the parent's rate.

Here's what changed under the new law: The Kiddie Tax may now apply depending on your child's age, status as a student, and earned income. Unfortunately, the new rules are complicated. In fact, there are actually three Kiddie Tax rules that apply if the other requirements are met:

Rule 1 - If your child has not reached age 18 at year end (in other words, he or she is age 17 or younger on December 31).

Rule 2 - If your child is age 18 at the end of 2008, and he or she doesn't have earned income that exceeds half of his or her support.

Rule 3 - If your child is age 19 through 23 at year end, is a student and doesn't have earned income that exceeds half of his or her support. A child is generally considered a student if he or she attends school full-time for at least five months during the year.

It does not matter whether a child in the above categories is claimed as a dependent on a tax return. And in the case of students, support does not include amounts received as scholarships.

Other options: The new law makes Section 529 college savings plans and Coverdell Education Savings Accounts more attractive because investments in them are not subject to Kiddie Tax. Consult with your tax adviser for more information about how to proceed in your situation. Call Ronald J. Cappuccio, J.D., LL.M.(Tax) Counsellor at Law at (856) 665-2121.

Virtualex.com Ronald J. Cappuccio, J.D., LL.M.(Tax) 1800 Chapel Avenue West Suite 128 Cherry Hill, NJ 08002 Phone:(856) 665-2121      Fax: (856) 665-9005 Email: ron@taxesq.com
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