Kiddie Tax Planning

2007 Offers One Last Tax-Saving Opportunity

Based on recent tax legislation, it’s apparent Congress doesn’t like higher income taxpayers reducing their family tax burden by shifting income to their teenage and college-age children.  Between the Tax Increase Prevention and Reconciliation Act of 2005(TIPRA) and the Small Business and Work Opportunity Tax Act of 2007 (SBWOTA), Congress has rapidly hiked the age at which the kiddie tax applies from under age 14 all the way up to age 23, if certain conditions apply.  Fortunately, however, the latest round of the age increase doesn’t kick in until 2008.  Thus, 2007 offers many taxpayers one last chance to avoid the kiddie tax rules.

Background

Under the kiddie tax rules, a portion of a child’s investment income can be taxed at his parents’ marginal tax rate rather than his own.  The kiddie tax applies when a child meets the following requirements: 

1. Has at least one living parent in a higher tax bracket than the child.
2. Doesn’t file a joint return.
3. Has unearned income over a threshold amount ($1,700 for 2007) and
4. Meets an age requirement.

TRIPRA extended the age requirement from under age 14 to under age 18.  More recently, the SBWOTA went one step further, extending the age again to certain children age 18, or age 19-23 if a full-time student.

Thus for 2008 and later years, if a child meets the first three requirements above and any of three age requirements that follow, the kiddie tax applies.  The three age requirements are:

• Under age 18 at year-end.
• Age 18 at year-end if his or her earned income is 50% or less than the amount of his or her support.
• Age 19-23 at year-end if a student and if his or her earned income is 50% or less than the amount of his or her support.  Presumably, a child is considered to be a student if he or she attends school full-time for at least five months during the year.

The Kiddie tax applies to all children that meet the requirements (they don’t have to be a dependent).  Also, for items 2 and 3 above, the child’s support doesn’t include any amounts received as scholarships.

2007 Planning Strategy

Since the recent age increase doesn’t take effect until 2008, taxpayers with children not subject to the kiddie tax in 2007 (generally age 18 or older) but who will be subject to it in 2008 have one last opportunity to avoid the negative impact of the kiddie tax.  (This normally will include college students and some high school seniors.)  Investment income recognized by these children in 2007 is not subject to the kiddie tax.  Therefore, long-term capital gains will be taxed at the child’s 5% capital gain rate versus the 15% rate that will likely apply in 2008 when the child’s parents’ rate is applied.

So whether parents (or grandparents) gift appreciated securities to the child in 2007 or the child has an existing custodial account with appreciated securities, it’s important to consider selling these securities before year-end to take advantage of the child’s 5% capital gain rate.  Otherwise, waiting until 2008 or later could result in an applicable tax rate of 15% (or higher if capital gain rates increase) because of the kiddie tax.

 Other Considerations

Don’t overlook the following when considering this strategy for 2007: 

• Financial aid.  An increase in the student’s income can have a detrimental impact on the amount of financial aid a student might receive.  Therefore, if the student is currently receiving or expects to receive financial aid, it is important to assess the impact of the child recognizing additional income in 2007.
• Gift tax annual exclusion.  If gifting appreciated securities to the student in 2007, don’t forget that the 2007 annual gift tax exclusion amount is $12,000.  For parents, their combined exclusions will enable them to gift up to $24,000 to the student without gift tax consequences.

Conclusion

The delayed effective date of the most recent increase in the kiddie tax age provides many taxpayers, particularly those with children already in college or who are entering college in 2008, one last chance for avoiding the detrimental impact of the tax.  However, time is quickly running our, so now is the time for taxpayers to review their situations so appropriate action can be taken before the year-end.