For further information about this column, contact Mr. Schulman at michael@schulmancpa.com or Prof. Sumutka at sumutka@rider.edu.

Section 510 of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) expanded the “kiddie tax” from children under age 14 to those under age 18, starting in 2006. Not only can the increase in age affect a family’s income taxes, but it might also adversely affect a child’s college financial aid awards.

Considerations

Pre-TIPRA law and planning: Special rules under Sec. 1(g) (the kiddie tax) are designed to minimize the family income tax advantage obtained when (1) parents gift assets to a child, (2) the investment income is taxed at the child’s lower income tax rates and (3) family wealth increases. Before the TIPRA, Sec. 1(g) provided that a child under age 14 who had unearned income (e.g., interest, ordinary dividends, capital gains, etc.) in excess of $1,700 (in 2006) was taxed at the parents’ highest marginal income tax rate, but only if the child had a living parent at the end of the year and the tax at the parents’ rate exceeded the tax at the child’s rate. Under Sec. 1(g)(3), if a child’s un-earned income included net capital gains and/or qualified dividends, it was allocated between the parent and the child (because, under Sec. 1(h), different capital gain/qualified dividend income rates of 15% or 5% (0% from 2008–2010) apply).

Because the kiddie tax is imposed only on unearned income in excess of $1,700, unearned income below that threshold is taxed at the child’s rate. Thus, a well-publicized and effective pre-TIPRA strategy was to purchase no-, low- or deferred-income-generating investments (e.g., growth stocks or U.S. Series EE/I savings bonds) for a child under 14. When the child attained age 14 or more, the assets were typically sold or redeemed, because the tax no longer applied.

Post-TIPRA law and planning: For tax years beginning after 2005, the kiddie tax applies to a child under age 18, under Sec. 1(g)(2)(A), but not to one who is married and files a joint return; see Sec. 1(g)(2)(C).

The current planning wisdom appears to be the same as the pre-TIPRA strategy, except that investments should now be held until the child is at least 18, then disposed of. Although the opportunity to lower taxes by transferring income-producing assets to children under 18 is curtailed by the kiddie tax, putting a child’s funds in investments that produce little or no current taxable income can help avoid the tax; see RIA’s Complete Analysis of the Tax Increase Prevention and Reconciliation Act of 2005, ¶204.

Further, parents who had planned to sell a child’s college stock portfolio in 2006 when the child reached 14 now have to wait if they intend to take advantage of the latter’s lower tax rate. If the parents plan to postpone a sale until 2008 when the child’s capital gain rate could be zero, they have to make sure that he or she reaches 18 by then; otherwise, the gain will still be taxed at the parents’ (presumably higher) rate (see CCH, Tax Increase Prevention and Reconciliation Act of 2005: Law and Explanation, ¶210).  

Financial Aid Considerations

Clearly, these planning ideas help avoid the expanded kiddie tax and are appropriate for students unlikely to qualify for financial aid. However, the potential combination of substantial assets held and income earned by an 18-year-old, otherwise financial-aid-eligible student, who is about to enter college, can be disastrous. The lost financial aid over four years of college may surpass the tax savings earned by kiddie tax avoidance, which brings into question the wealth maximization benefits of the recommended income tax strategy.

Financial aid laws and implications: According to the “2006–2007 Free Application for Federal Student Aid” (FAFSA), a student who seeks Federal financial aid and plans to enter college in September 2007, for example, must file an application no earlier than January 2007. The process is repeated annually. The applicant must report his or her own income and the parents’ income for the preceding calendar year (e.g., 2006) and assets as of the date the application is signed; see www.fafsa.ed.gov.

Generally, 50% of a student’s income (e.g., from the sale of investment assets) is presumed to be available to fund college expenses, while the parents’ income is assessed at rates from 22%–47%. While 35% of a student’s assets (e.g., the cash received from asset dispositions) is assessed, only 2.64%–5.64% of the parents’ assets is considered. The marginal rates are applied after various deductions and allowances. Assessments reduce financial aid awards. (The calculation of the “expected family contribution” is detailed in Section 471 of the Higher Education Act of 1965; for more information, see Sumutka, “College Aid and Tax Planning (Part I),” The CPA Journal (February 2004), available at www.nysscpa.org/cpajournal/2004/204/essentials/p54.htm.)

Thus, for financial aid purposes, (1) planning strategies are most effective if implemented at least two calendar years before the date of anticipated college entry (i.e., generally when a child is 16); (2) assets and/or income held and/or earned by students are treated less favorably than if held and/or earned by parents; and (3) assessments calculated at a marginal financial aid assessment rate have a similar wealth-reducing effect as income taxes calculated at a marginal income tax rate.

Example 1: A, a financial-aid-eligible student, sells appreciated stock for $10,000 and generates $1,000 long-term capital gain. The gain is subject to a 50% financial aid assessment (after deductions and allowances) and a 5% marginal income tax rate. If A holds the proceeds on the date she signs the FAFSA,  they are subject to a 35% financial aid assessment. Thus, A’s financial aid award will be reduced by $4,000 ($500 on the gain + $3,500 on the assets); A pays $50 income tax, resulting in a $4,050 reduction in her wealth.

Example 2: B’s parents sell appreciated stock for $10,000 and generate $1,000 long-term capital gain. The gain is subject to a 47% financial aid assessment (after deductions and allowances) and a 15% marginal income tax rate. If B’s parents hold the proceeds when the FAFSA is signed, they are subject to a 5.64% financial aid assessment. Thus, B’s financial aid award is reduced by $1,034 ($470 on the gain + $564 on the assets) and B’s parents pay $150 income tax, resulting in a $1,184 reduction in their wealth. Thus, B’s family’s wealth is $2,866 higher than A’s in Example 1 above ($4,050 – $1,184), because the asset was held by B’s parents, instead of B.

Pre-TIPRA planning: A viable kiddie tax and financial aid strategy was for a child to hold no- or low-income-yielding assets until age 14, to keep unearned income below the kiddie tax threshold. When the child was no older than 16, the assets were disposed of, so the income was taxed at the (presumably lower) child’s rate and not counted for financial aid purposes. The resulting countable asset (e.g., cash) was then depleted by purchasing a noncountable asset (e.g., a computer, automobile, etc.) before the FAFSA was signed.

Financial aid trap: The TIPRA suddenly and unexpectedly closed this loophole, and places unsuspecting parents and students in a financial aid trap.   Many students enter college at 18, at a time when planning under the expanded kiddie tax suggests selling assets. However, a student who holds assets until age 18, then sells them, might create a combination of countable assets and countable income (which decreases financial aid), coupled with an income tax liability.

Of course, to eliminate the countable asset, the cash can be spent during the year the application is filed, but before it is signed (e.g., from Jan. 1, 2007 through the date signed in 2007). However, arguably few taxpayers are aware of this financial aid strategy, and the potential timeframe for implementation is very narrow. In any event, the income generated from a 2007 sale is reflected in the following year’s FAFSA, which reduces financial aid at that time.

Post-TIPRA implications and planning: With the extension of the kiddie tax to children under 18, the TIPRA further erodes the income tax benefits of asset/income shifting from parents to children. As noted, financial aid formulas are already skewed against child-owned assets and/or income. The TIPRA eliminates the efficacy of traditional financial-aid-planning strategies for the shifted assets and greatly reduces the timeframe for successfully implementing new strategies as well. Parents whose children may receive more financial aid than the parents may receive in income tax benefits now have further reason to reject the age-old tactic of gifting assets to their children, and should plan for the orderly disposition of the children’s existing assets.

As previously noted, if financial-aid-eligible children currently own assets, it may be wise to plan for liquidation at least two calendar years before their anticipated enrollment in college. Thus, Dec. 31, 2007 is the last date for students projected to enter college in September 2009 to generate income that will be ignored in financial aid determinations, although the income may be subject to the expanded kiddie tax.

Example 3: C, age 16 in 2007, plans to enter college in September 2009 at 18. If C sells appreciated stock in 2007, the gain is subject to 2007 income tax (and possibly the kiddie tax, depending on the amount of his unearned income). However, it is not reported on his first FAFSA, which includes only 2008 income.

Unfortunately, students projected to enter college in September 2008 may be in a financial aid trap, because income earned on asset dispositions in 2007 or 2008 is counted for financial aid purposes and subject to income tax. Nonetheless, immediate liquidation and depletion of the assets eliminate them as future countable assets and countable income.

Example 4: D, age 17 in 2007, plans to enter college in September 2008 at 18. If D sells her appreciated stock in 2007, the gain is subject to 2007 income tax (and, possibly, kiddie tax) and is reportable on her first FAFSA. If she uses the proceeds to purchase, for example, a computer before she signs the FAFSA in 2008, the proceeds are not included as an asset on the FAFSA.

Younger, low-income children who own moderately appreciated assets appear to be well-positioned to implement effective income tax and financial aid planning. For them, the sale of appreciated capital assets should be structured to occur from 2008–2010, when most long-term capital gains are tax free for income normally taxed in the 15% tax bracket or lower and below the kiddie tax unearned income threshold; see Sec. 1(h)(1)(B) and (g)(3). Otherwise, as was noted above, the gain will still be taxed at the parents’ (presumably) higher rate.

Example 5: E, age 13 in 2007, plans to enter college in September 2012 at 18. If E sells appreciated stock from 2008–2010 (at ages 14–16) and the resulting long-term capital gain and other unearned income are less than the unearned income threshold for the kiddie tax, the gains are excluded from income taxation and not reportable on his first FAFSA. E accumulates proceeds and, like D in Example 4 above, later uses them to avoid including them on his first FAFSA.

Other young children with more highly appreciated assets should consider systematic annual dispositions over a number of years, so that they can smooth income, possibly avoid or lessen the kiddie tax and eliminate assets and income from financial aid consideration.

Example 6: F, age 10 in 2007, plans to enter college in September 2015 at 18. F’s stock has appreciated more than E’s stock in Example 5 above. F systematically sells her appreciated stock from 2007–2013 (ages 10–16) and limits her gains and other unearned income to the kiddie tax unearned income threshold. All income is taxed at F’s rate (including 0% from 2008–2010) and none of it is reportable on her first FAFSA. F uses the same strategy as D and E in Examples 4 and 5 above to avoid including the proceeds on her first FAFSA.

Is there a plausible strategy for parents who have not gifted assets to a child and conclude that future gifting might negatively affect his or her financial aid? As was noted, financial aid applications require financial data only about parents and children, not grandparents. Thus, the TIPRA increases the attractiveness of grandparent-owned/grandchild-beneficiary Sec. 529 plans that can be (partially) funded by parents.

Conclusion

The TIPRA complicates kiddie tax planning, further reduces the family wealth creation benefits of parental gifting to financial-aid-eligible students, and underscores the growing need for tax advisers to understand the financial aid consequences of tax planning.