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.
Here's how I make sense of all this. For unearned income, the dependent's standard deduction starts at $950 and stays there if there is no earned income. Once the child begins to have earned income, the first $650 will not cause any increase in the standard deduction--but after that, each additional dollar earned will increase the standard deduction by a dollar (effectively making the earnings tax-free) until the standard deduction reaches the amount that would be allowed if your child were not a dependent. For 2011, that amount is $5,800.
When a child has both earned and unearned income, you need to deal with each type of income separately to calculate the tax. Suppose Jane has $3,100 of interest income and she earned $1,200 as a lifeguard during the summer. Her standard deduction for the investment income is $950. Her remaining standard deduction for her earned income is $1,200 + $300 = $1,500 less the $950 applied to her unearned income leaving $550. Her tax would be calculated as follows:
First $950 of interest income: no tax
Second $950 of interest income: taxed at 10% = $95
Balance of $1,200 interest income: taxed at parent's 35% rate = $420
$1,200 earned income less remaining deduction of $550 is $650: taxed at 10% = $65
Jane owes $160 tax at her bracket, plus $420 tax at her parent's bracket.
How Kiddie Tax is Reported
Any taxable earned income is reported on the child's return, so in this case Jane would need to file a return to pay the $65 tax on her earned income. The excess of investment income over $1,900 can be reported on the child's tax return using Form 8615 or on the parent's tax return using Form 8814. In many cases, the reportable income is below the threshold for state income taxes, so reporting on the child's return will save the state tax. In prior years when there were phase-outs to deductions based upon income, keeping the income on the child's return may have prevented further limitations to deductions. There are no phase-outs for tax years 2010 or 2011.
When the child has no earned income, reporting the investment income on the parent's return can save the cost of filing another return.
Who is the Parent?
If the parents decide to report the taxable unearned income their return, we need to identify which parent's return to use. The rules are:
* If the child's parents are married to each other and filed a joint return, the parent listed first on the joint return is the parent.
* If the parents are married and filed separate returns, the parent is the one with the highest taxable income.
* If the parents lived apart and are unmarried, separated or divorced, the parent is the custodial parent.
* If the parents are unmarried but lived together, the parent is the one with the highest taxable income.
The option to report the child's investment income on the parent's return is only available if the investment income is from interest and dividends (including capital gain distributions from mutual funds). It is not available if the child has capital gain income such as from the sale of stock. The child's gross income for the year must also be below $9,500 for 2010 and 2011 in order to report their investment income on the parent's return.
Is there any other way?
Remember that the kiddie tax only applies to unearned income. If your client has an unincorporated business activity that they report on their schedule C, they can hire their kids. The children will owe no tax on earned income up to $5,800 for 2011. As family members they will owe no social security up to their age 18. Of course they need to perform actual work, parents need to keep records and give the children a W-2 at the end of the year. For middle-school and high-school age children, it is perfectly reasonable that they can do basic office type tasks such as scanning, filing, and shredding.