Tax Planning Arbitrage to Avoid the Kiddie Tax
1986 resulted sweeping tax legislation, the breadth of which had not been seen since 1954. Among the then new provisions was the “Kiddie Tax” designed to avoid tax rate arbitrage resulting from parents shifting their income to a child’s lower marginal income tax rate.
Originally, the mandatory inclusion of children’s income in the parents’ income taxes at a higher marginal tax rate was no longer required after the child’s 14th birthday. That changed, however, when the age threshold was increased to 24 for children who are still in school – pretty much all children these days.
There is, however, a creative tax planning opportunity to circle around the kiddie tax that works for college students. The opportunity exists because there are so many disjointed soak-the-rich provisions in the tax code that on occasion they cancel each other out. Penalties are not limited to the Kiddie Tax, and include loss of personal exemption and loss of the ability to avail themselves of the American Opportunity Tax Credit for tuition which is worth $2,500.
Consider the scenario where parents have a marketable security they would like to sell resulting in a $10,000 long term capital gain. Parents have a kid in college but, because their income is more than $180,000, they are ineligible for the tuition credit. Let’s further assume that the parents cannot claim personal exemptions because either their income is above $422,500 or they are subject to the Alternative Minimum Tax.
Instead of selling the stock, mutual fund, exchange traded fund, etc., the parents might consider gifting the stock to the child who sells it to cover the tuition bill. Parents must not list the child on their return as a dependent as they are ineligible in any event in this case. The child then reports the capital gain on his or her return and the capital gains tax is effectively wiped out by the tax credit. In effect, the Kiddie Tax disappears, which is what happens when the tax code comes after taxpayers from three directions.
All is not lost if you do not qualify for the above-discussed tuition play. Consider the earned income escape hatch where the child living frugally (working part time and attending a cheap state college or more costly institution and receiving a merit grant) is able to cover half of their living expenses, including tuition, from wage or salary earnings, making them eligible for being taxed separately from the parents. That means the child can claim the personal exemption worth $3,900 for 2013, and the full standard deduction of sixty-one hundred dollars. With these advantages, junior can seize upon a 0% tax rate on dividends up to where his income hits $36,250.
What if the Kiddie is too young to work. In such case, the $2,000 tax grace allowance against the Kiddie Tax may be appealing, providing for a two year old with a $90,000 stock portfolio paying no tax on dividends.
The above information is provided for general information purposes only, and does not constitute legal advice. Successful implementation of the above-described techniques requires careful consideration of facts particular and unique to each situation and, therefore, should only be considered after a detailed consultation with an attorney. The above information is not intended to create an attorney-client relationship between the Law Offices of Daniel D. Kopman/Kopman Law and the reader. Such relationship would only arise, if at all, upon negotiation and execution of a written fee agreement.