Kiddie Tax Changes for 2008

The tax imposed by Sec. 1(g) on the unearned income of minor children is commonly referred to as the “kiddie tax.” Its purpose is to prevent wealthy parents from shifting unearned income or investment income to their children, who presumably are in a lower tax bracket. The Code achieves this by applying the parents’ highest tax rate on the child’s unearned income.

Earned income includes wages, tips, contract service income, self-employment net income, and other payments for personal services performed. Unearned income is generally investment income—e.g., interest, dividends, capital gains, rent, royalty, Social Security, and beneficiary distributions.

In 2006, the kiddie tax applied if the following conditions were met:

1. The child’s unearned income exceeded twice the child’s standard deduction of $850 (i.e., $1,700);
2. The child was under age 18 at the end of the year;
3. One of the child’s parents was alive at the end of the year;
4. The child was required to file a tax return; and
5. The child did not file a joint return.

Age Group Expanded

The Small Business and Work Opportunity Tax Act of 2007, P. L. 110-28, did not change the basics of the kiddie tax, but broadened its application to include more children. The kiddie tax historically covered children who were of an age that they would still be at home and under parental influence. Now the tax includes the age group that has moved out of the house and is learning to make independent decisions but still needs some parental support to survive. The updated kiddie tax criteria now extend to all children under 19 with the above-stated conditions. The kiddie tax now also applies to a child aged 19–23 if:

1. The child is a full-time student before the close of the tax year; and
2. The child’s earned income does not exceed one-half of his or her support.

There are a few obvious effects from this change. Children and college students from middle-class and wealthy families will owe more taxes due to exposure to their parents’ higher rates. Children who generate savings and investments independent of their parents may now need to consult with them on their tax-filing requirements. The advantages to parents from shifting investments that generate current-year income to their lower-tax-bracket children diminish. Gifts of investments may need to be restructured.

The potentially bigger fallout is the effect from the capital gains rates for the lowest income brackets in 2007 and 2008. For those in the lowest tax brackets, the capital gains rate is 5% in 2007 and 0% in 2008; it is 15% for higher brackets. Many individuals may have shifted appreciated assets to the children in expectation of selling the assets in 2008 and benefiting from the 0% tax rate on the net gain on the child’s side. The expansion of the kiddie tax essentially eliminates these rates for any families trying to shift capital gains to the child’s lower tax bracket.

New Strategies and Alternatives

The kiddie tax changes are effective for tax years after May 25, 2007. For most taxpayers, this will affect their 2008 tax filings. So now is the time to consider new strategies and alternatives:

1. Earned income is not taxed at the parents’ rate. Even if the child has unearned income subject to the kiddie tax, any earned income will still be taxed at the child’s own rates (which are usually lower). Under Sec. 152(c)(1)(D), earned income can also help with the support test that exempts the child from the kiddie tax. Children who earn enough income to cover half of their support are not subject to the kiddie tax (and the parents cannot take a dependency deduction).
2. The child is employed in the family business. This expands on the previous point. The income to a child employed in the family business is earned income and helps with the support test. The wages create ordinary deductions for the family business and could reduce dividend payouts. Self-employed individuals can employ their child under age 18 and do not have to pay FICA (Sec. 3121(b)(3)(A)); if the child is under 21, they do not have to pay FUTA taxes (Sec. 3306(c)(5)). In a partnership, the parents must be the only partners in order to reap the same employment tax benefits (Regs. Sec. 31.3121(b)(3)-1(c)). Of course, any compensation must be for legitimate work and at a reasonable wage.
3. Sell investments in 2007 instead of 2008. If the intent of the individual was to benefit from the low capital gains rates over the next two years, they may want to sell the appreciated stock or mutual fund holdings before the end of the year. If sold in 2007, the child’s capital gains rates (typically 5%) will apply instead of the parents’ rates (15%).
4. Invest and/or move investments to vehicles that generate capital growth over income-producing property. Consider investments in high-growth, low-dividend stocks and funds, stocks in a closely held business, tax-exempt municipal bonds, U.S. series EE savings bonds (interest is deferred until the bond is cashed in), and vacant land expected to appreciate. Be careful when dealing with vacant land if incidental sublease income should be incurred, as this is unearned income subject to the kiddie tax.
5. Consider contributing to investments that do not generate taxable income. Contribute to a traditional or a Roth IRA. The child must have earned income in order to make the contribution. Children may also get a deduction for the IRA to the extent of their earnings (as long as they are not covered under another retirement plan), so their taxable income can be lowered. Coverdell education savings accounts (Sec. 530) and qualified tuition programs (Sec. 529) allow investment income to be tax exempt, and children pay no tax when they withdraw from the accounts for their education.
6. Hold off on shifting income-generating investments until the child reaches age 24. Individuals moving stocks that generate dividends could consider whether the dividend income creates enough unearned income to trigger the kiddie tax. If the individual is trying to transfer gifts to a child, his or her portfolio should be reviewed for investments that meet point 4 above and do not generate current-year payouts that are income.

Conclusion

If children are under age 24 on December 31, 2007, it would be wise to readdress their investment portfolios. Until the student child turns 24, parents need to be aware of their child’s unearned and earned income to determine the support test for the kiddie tax. Parents may need to consider employing children in the family business, reviewing their gifting strategy, and investing in IRAs and education savings programs in which withdrawals are tax free and benefit the student.

From Cynthia Dulworth, CPA, and Clint Cockrell, CPA, Sanford, Baumeister & Frazier, PLLC, Fort Worth, TX

Some Prior-Year MTCs Will Be Refundable Beginning in 2007

A growing number of individual taxpayers have been subject to tax under the alternative minimum tax (AMT). Sec. 53(a) provides a minimum tax credit (MTC) for AMT paid in prior years that was attributable to deferral adjustments. The MTC is carried forward to offset regular tax liability in future years. Frequently, however, little or none of the MTC is allowable because in subsequent years the individual’s tentative minimum tax under Sec. 55(b) is close to (or exceeds) the individual’s regular tax.

Some individuals have large amounts of MTC, frequently caused by AMT resulting from the exercise in past years of incentive stock options (ISOs). Many of those taxpayers exercised their ISOs and paid significant AMT in the year of exercise but were caught in the “tech bust” of the early 2000s and saw the value of the exercised shares plummet so quickly that they were lucky to receive enough in the shares’ sale proceeds to cover the previous year’s AMT. Given the nonrefundable nature of the MTC and the limitations of Sec. 53(c), many of these individuals are unlikely to recoup much of the MTC during their lifetimes.

In December 2006, Congress added Sec. 53(e) to address this situation. New Sec. 53(e)(4) states that the MTC allowed under Sec. 53(e) “shall be treated as if it were allowed under subpart C,” which refers to the refundable credits of Secs. 31–36. Thus, MTC generated by Sec. 53(e) is refundable, even when it exceeds the taxpayer’s liability. Many individuals will begin in 2007 to draw down a portion of the accumulated unused MTC, but in many cases planning will be needed if they are to maximize the amount of refunds allowed by this new provision.

The New Rules

The changes cover tax years beginning after December 20, 2006, but before January 1, 2013. Taxpayers who have long-term unused MTC are entitled to an MTC equal to the greater of the AMT refundable credit amount or the amount of allowable MTC under the preexisting Sec. 53(c) limitations, but subject to important adjusted gross income (AGI) phaseouts. “Long-term unused MTC” is defined as unused MTC from tax years before the third tax year immediately preceding the tax year in which the credit is taken. The “AMT refundable credit amount” is equal to the greater of (1) the lesser of $5,000 or the amount of long-term unused MTC for the tax year or (2) 20% of the amount of long-term unused MTC. See exhibit.

AGI Phaseout

Sec. 53(e)(2) further limits the refundable MTC for high-income taxpayers by using the same phaseout rules (Sec. 151(d)(3)(C), as adjusted for inflation under Sec. 151(d)(4)(B)) that govern the phaseout of personal exemptions. In 2007 the MTC is reduced by 2%, but not below 0%, for each $2,500 or fraction thereof ($1,250 for marrieds filing separately) by which the taxpayer’s AGI for the tax year exceeds $234,600 for a joint return, $195,500 for head of household, $156,400 for single, and $117,300 for married filing separately. Also, for purposes of the AMT refundable credit, Sec. 53(e)(2)(B)(i) provides that AGI is determined without regard to the income exclusions of Secs. 911, 931, and 933.

Example: In 2007, D and J have a $250,000 total MTC, of which $200,000 is long-term unused MTC carried forward from tax years before 2004. Because their long-term unused MTC is greater than $25,000, their AMT refundable credit amount is $40,000 (20% of $200,000). Therefore, at this point the MTC they are allowed for 2007—before any AGI phaseout—cannot be less than $40,000.

D and J’s 2007 AGI is $261,600 ($27,000 above the $234,600 AGI phaseout threshold). Therefore, their allowable MTC is subject to a partial phaseout of $8,800 (22% of $40,000), leaving an allowable MTC of $31,200 ($40,000 2 $8,800) at this point.

D and J’s 2007 regular tax liability is $30,000, and their tentative minimum tax is $26,000. Assuming there are no other credits, their allowable MTC is $31,200—the greater of their AMT refundable credit amount ($31,200) or the amount of MTC otherwise allowable ($4,000 [$30,000 regular tax 2 $26,000 tentative minimum tax]).

Of the $31,200 allowable MTC, the “otherwise allowable” $4,000 portion of the credit is nonrefundable, leaving $27,200 as refundable. The remaining $218,800 of unused MTC is carried forward to future tax years.

Maximizing the Refundable MTC

Before the enactment of Sec. 53(e), individual taxpayers could obtain MTCs on their current returns only by using planning techniques that increased the spread between their regular tax and tentative minimum tax. For higher-income individuals, whose AMT exemption amounts are phased out under Sec. 55(d)(3), this might mean acceleration of ordinary income into the current year. With those individuals who had some or all of their AMT exemption, the opposite approach is commonly used. This latter technique can be particularly effective for taxpayers in the “AMT zone,” in which each dollar of reduced AMT income increases the AMT exemption amount by $1.25.

New Sec. 53(e) increases the importance of AGI, because AGI acts as a gatekeeper for the refundable MTC. Thus, individual taxpayers should attempt to keep AGI under the threshold in as many years as possible before 2013.

One uncertainty with the AGI phaseout is that Sec. 151(d)(3)(E) provides for reductions in the personal exemption phaseout amounts for the years 2006–2009. While Sec. 53(e)(2) incorporates the provisions of Secs. 151(d)(3)(B) and (C), which relate to the general phaseout percentages and amounts, it does not refer to the reduction of the phaseouts under Sec. 151(d)(E) for the years 2006–2009. If the Sec. 151(d)(E) reduction of one-third applies to the phaseout amount of the refundable MTC in 2007, D and J would have received an additional $2,933 ($8,800 3 1/3) in the above example.

Conclusion

New Sec. 53(e) provides an opportunity for many individuals to receive refunds from a liberalized definition of the MTC. Tax advisers should assess the availability of these refunds, which will often depend on planning for and monitoring their clients’ AGI.

From Timothy P. Zainer, CPA, and Ben Young, Zainer Rinehart Clarke, Santa Rosa, CA