The IRS rules can be confusing.
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Shifting income to those in lower brackets is an effective tax planning strategy. It's so effective that there is a confusing set of rules that limits its value. Without an awareness of these rules, income received by your client's children could create an unwelcome tax surprise.
Income is normally taxed to the individual who receives it. If your client is in a 35% marginal bracket, he pays 35% tax on the last dollars received. This creates an enticement for clients to shift investment income to their minor children, who are usually in the lowest brackets for ordinary income.
The 10% bracket extends to $8,500 of taxable income for 2011. The 15% bracket extends to $34,500 for unmarried taxpayers. A classic strategy was for parents to gift income-producing assets to custodial accounts under the Uniform Trust to Minors Act for their children. The income from these accounts is taxed to the child's social security number while the parent retains control until age 18 or 21 depending upon the state. Net investment income payable to dependent children from trusts is also considered to be the child's unearned income.
Who qualifies as a "Kiddie"?
A dependent child is one that could be claimed as a dependent on their parent's tax return. It used to be that only dependent children under age 14 on Dec. 31 were considered kiddies for this tax. As of 2008, it automatically includes all children with investment income until the year they turn 18. In their 18th year, the kiddie tax applies to their investment income unless they earn more than half of their overall support. Children age 19 through 23 will be subject to the kiddie tax if they are full-time students during any part of at least five months during the year, unless the child's earned income is more than half of his or her overall support.
Investment Income Triggers the Tax
The kiddie tax is triggered when a child's unearned or investment income exceeds the threshold limit which is $1,900 for 2010 and 2011. This amount equals two times the standard deduction for unearned income of $950.
How the Kiddie Tax Works
In 2010, Jane who is 20 and a full-time student has $3,100 of interest income and no earned income. The first $950 of investment income is not taxed because of Jane's standard deduction (often referred to as the 1st $950). The next $950 is taxed at Jane's rate of 10%. That leaves $1,200 to be taxed at whatever rate would apply if this income were added to the income reported on her parent's tax return. If they are in the 35% tax bracket, the tax would be 35% of $1,200, for a total tax of $515. Even though the tax is calculated at the parents' rate, it is still Jane that owes the tax, not her parents.
Adding Earned Income to the Mix
It gets more complicated when the child has investment income of more than the $1,900 threshold plus earned income. The standard deduction for earned income is the greater of $950 or their actual earned income (up to $5,500 for 2011) plus $300.