Congress Not Kidding Around - Kiddie Tax Gets Tougher

Now Congress has done it again, toughening up the provision in the Small Business and Work Opportunity Tax Act of 2007 (SBWOTA) signed into law this past spring. But there’s still time to take advantage of the pre-SBWOTA rules.

A brief history

Legislators designed the kiddie tax to prevent taxpayers from shifting an inordinate amount of income-producing assets to their children to save on taxes.

Essentially, for children subject to the tax, the first $850 in unearned income (such as interest, dividends and capital gains) is tax free and the next $850 is taxed at their own rate (usually 10% for interest, nonqualified dividends and short-term capital gains, and 5% for qualified dividends and long-term capital gains). But any unearned income over $1,700 is taxed at their parents’ marginal rate (currently as high as 35% or 15%, respectively).

The cutoff for the kiddie tax used to be age 14. But, with the signing of the Tax Increase Prevention and Reconciliation Act of 2005 (effective starting in 2006), the cutoff age was raised and the child must have reached age 18 during the year to avoid the tax.

Now SBWOTA broadens that rule beginning in 2008 to include those who qualify as dependents because they are either under age 19, or under age 24 and a full-time student, if their earned income doesn’t exceed one-half of the amount needed for their support.

What to do this year

With the tightened restrictions, 2007 may be the perfect year to shift highly appreciated assets to children 18 to 23 who will be subject to the kiddie tax next year. If they sell the assets by year end, they’ll pay tax at their own (likely lower) rate, saving your family tax dollars.

Suppose you and your spouse give your 18-year-old $24,000 in stock in which your basis is only $2,000. If you hadn’t already made gifts to your child for the year using your $12,000 annual gift tax exclusions, the transfer would be gift-tax-free. (If you already had used up the exclusions or you wanted to make a larger gift-tax-free transfer, you could use some of your and your spouse’s $1 million lifetime gift tax exemptions.)

Then say your child sells the stock by Dec. 31. Assuming he or she is in the 15% tax bracket, the $22,000 gain would be taxed at a 5% rate, for a tax of $1,100. In other words, you would save $2,200 in taxes.

Only the beginning

The revised kiddie tax is only the beginning of tax law changes affecting individuals over the last couple of years. The Tax Relief and Health Care Act of 2006, for instance, extended provisions regarding the state and local sales tax itemized deduction as well as the above-the-line deduction for college tuition payments. Consult your tax advisor about how any of the recent tax law changes may affect you.

(Source: http://www.irs.gov/formspubs/article/0,,id=164272,00.html)

*other gain means any gain that is not collectibles gain, gain on qualified small business stock, or unrecaptured section 1250 gain.

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