OLDER "KIDDIES" NOW SUBJECT TO HIGHER TAX

In 2006, Congress raised the age for the kiddie tax to apply from under age 14 to under age 18.  As part of the Small Business and Work Opportunity Tax Act of 2007, signed into law in May, the applicable age has been raised to under 19.  And the Act also creates a new group of children to the kiddie tax--those under age 24 who are (1) full time students, (2) do not earn enough to provide more than half of their own support, and (3) do not file a joint return.

If the kiddie tax applies, the child’s investment income above $1,700 (adjusted for inflation)— interest, dividends and capital gains — is taxable at the parents’ rates.  Many people, wealthy, and not so wealthy, have invested assets in their children’s names in order to obtain a lower tax rate.  Frequently, this strategy was designed to permit accumulation of money for college education.  This change squarely attacks this strategy.

Are there ways to avoid, or soften, the impact of this new law?  Yes.

First, the new law does not apply for calendar year taxpayers until January 1, 2008.  So, if the child is not subject to the kiddie tax now, but would be under the new rules—for example, a child who is 20 this year but will be still meet the full time student test next year—you might accelerate income.  If you plan to turn in E bonds next year to pay tuition, do it this year and pay tax at the child’s rate.  Or if you intend to sell a stock at a substantial gain, you might be able to shift some of that gain into a 5% bracket from a later 15% bracket by selling this year.

Second, the kiddie tax does not apply to 529 plans.  These are plans that accumulate income and gains tax free, and do not subject the owner to tax if withdrawals are used to pay eligible education expenses.  The child (or a custodian for the child) can establish a 529 plan for the benefit of the child with money already in the child’s name.  (Unfortunately, 529 plans can only accept cash, so any investments in the child’s name must be sold, and may require recognition of tax in the process.)

Third, a parent who owns a business could make an older child an employee.  If the child earnings exceed half his or her support, the child will not be subject to the kiddie tax on investment income.  This exception only applies to persons over age 17.

Fourth, you might borrow the education costs and have the child incur tax and pay the loan back at a time when the kiddie tax does not apply.  But the child might be in a high tax bracket at that time, and you will incur interest expense which may not be deductible.  And remember, the top capital gains tax rate is scheduled to increase to 20% in 2010.

As always, each situation is different.

If you would like more information, contact:  Christopher Anderson (816.472.3117), John Dooling (314.259.4743), Jonathan Igoe (314.342.8019) or one of the other attorneys in the Tax, Employee Benefits and Trusts and Estates Practice Group.

Please feel free to pass this on to any colleague or client who may be interested in this information.

Internal Revenue regulations state that only a formal opinion that meets specific requirements can be used to avoid tax penalties.  Any tax advice in this communication is not intended or written to be used, and cannot be used by a taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer, because it does not meet the requirements of a formal opinion.