On May 25, the President signed into law H. R. 2206, the Iraq emergency supplemental appropriations bill (P.L. 110-28) containing the Small Business and Work Opportunity Tax Act of 2007 (the Small Business Act). Included in the Small Business Act are various small business tax incentives and a number of revenue raisers such as new and enhanced penalties and broadening of the kiddie tax, among other items. This Practice Alert explains the broadened kiddie tax and planning that can be undertaken to blunt its impact. 

Pre-Act kiddie tax rules. A child subject to the kiddie tax pays tax at his or her parents' highest marginal rate on the child's unearned income over $1,700 (for 2007) if that tax is higher than the tax the child would otherwise pay on it. (Code Sec. 1(g)) The parents can instead elect to include on their own return the child's gross income in excess of $1,700 (for 2007). (Code Sec. 1(g)(7))

A child is subject to the kiddie if he or she has not attained age 18 before the close of the tax year; either parent of the child is alive at the end of the tax year; and the child does not file a joint return for the tax year. (Code Sec. 1(g)(2)(A))

Broadened kiddie tax. For tax years beginning after May 25, 2007, the Small Business Act expands the kiddie tax rules to apply to children age 18, and children over age 18 but under age 24 who are full-time students—if their earned income doesn't exceed one-half of the amount of their support. (Code Sec. 1(g)(2)(A), as amended by Small Business Act § 8241(a))

Observation: The Small Business Act does not change the kiddie tax rules for children who are under age 18. Rather, it expands the kiddie tax to apply where:

• the child turns age 18, or turns age 19-23 if a full-time student, before the close of the tax year;
• the child's earned income for the tax year doesn't exceed one-half of his or her support;
• the child has more than the inflation-adjusted prescribed amount of unearned income (i.e., $1,700, as further adjusted for inflation for the applicable tax year);
• the child has at least one living parent at the close of the tax year; and
• the child doesn't file a joint return for the tax year.

Observation: This expansion of the kiddie tax rules attempts to curtail a strategy some wealthy (and some moderate-income) parents were advised to use to take advantage of a beneficial feature of the long-term capital gains rates—a feature that's scheduled to become even more beneficial in 2008.

This year, the top tax rate on “adjusted net capital gain”—i.e., most long-term capital gains and corporate dividends—is 15%. But to the extent a taxpayer's adjusted net capital gain would otherwise be taxed in the two lowest tax brackets—i.e., the 10% and 15% brackets—it's taxed at 5% for 2007, and 0% for 2008 through 2010. Some families sought to benefit from these rates by gifting appreciated stock, mutual-fund shares, and other securities to their low-income, young-adult children who (if no longer subject to the kiddie tax rules and if in one of the two lowest tax brackets) could then sell the securities tax-free in 2008, 2009, and/or 2010. The new law changes will eliminate the opportunity to do this in many cases. However, if the earned income of a child over age 18, or age 19-23 if a full-time student, exceeds one-half his or her support, the kiddie tax rules won't apply and he or she will be able to take advantage of the 0% capital gains rate next year.

Observation: The kiddie tax changes also can have a negative impact on families that did not engage in transfers of capital assets to children.

Recommendation: Earned income is always taxed at the child's tax rates. Thus, one way of providing a child with income without triggering increased tax liability under the kiddie tax rules is to employ the child (at reasonable compensation) in, for example, a trade or business owned by the parent. Computer-literate children, for example, could help with a variety of tasks. As a result, the child's earnings won't be subject to the kiddie tax and will generate a deduction for the family business (assuming the wages are reasonable for the work actually performed). As an added bonus, this could help to avoid the kiddie tax on unearned income of a child age 18 or age 19-23 if a full-time student.

For purposes of the kiddie tax, support is defined the same as it is for the dependency deduction requirement that a qualifying child not provide more than one-half of his or her own support for the tax year, but any scholarships received by a student for study at an educational organization described in Code Sec. 170(b)(1)(A)(ii) are excluded in determining the total support paid for the student for the tax year. (Code Sec. 1(g)(2)(A)(ii)(II))

Recommendation: Because of the Small Business Act changes, any planned transfers of income-generating stocks, bonds, and other investments to children age 18, or those age 19-23 who are full-time students, must be reconsidered or postponed to eliminate or decrease the child's unearned income.

Observation: Although the opportunity to lower taxes by transferring income-producing assets to children age 18, or children age 19-23 who are full-time students, is curtailed by the kiddie tax rules, investing a child's funds in investments that produce little or no current taxable income, can help avoid the kiddie tax. These investments include, for example, stocks and mutual funds oriented toward capital growth that produce little or no current income; vacant land expected to appreciate in value; stock in a closely-held family business that pays little or no cash dividends; tax-exempt municipal bonds and bond funds; and U.S. series EE savings bonds for which interest reporting may be deferred.

Investments that produce no taxable income, and that are therefore not subject to the kiddie tax, also include tax-advantaged savings vehicles, such as, traditional and Roth IRAs (which can be established or contributed to if the child has earned income); qualified tuition programs (“529 plans”); and Coverdell education savings accounts (“CESAs”).

Direct pick-up election. Under the kiddie tax rules, a parent can elect (on Form 8814) to include in the parent's gross income for the tax year the child's gross income in excess of $1,700 (for 2007) if certain requirements are met.

Observation: Doing so avoids the need to file a separate return for the child, and except where the child can claim certain deductions the electing parent can't (see below), the tax on the child's income will generally be the same whether the parent elects to report the income or the child files a separate return. However, whenever the election is made, it's important to consider that the addition of the child's income to the parent's adjusted gross income (AGI) may affect the various floors and ceilings for, and thus the amount of, the parent's deductions.

In addition, an electing parent can't take certain deductions that could be taken on the child's return absent the parent's election—for example, the child's itemized deductions such as the child's investment expenses or charitable contributions. Thus, where a child can claim any of these deductions, it's important to determine whether there will be a tax savings from having the child file a separate return.

Source:  Federal Taxes Weekly Alert (preview) 06/07/2007, Volume 53, No. 23 & RIA

CIRCULAR 230 NOTICE: IRS regulations require us to advise you that, unless otherwise specifically noted, any federal tax advice in this communication (including any attachments, enclosures, or other accompanying materials) was not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of avoiding penalties; furthermore, this communication was not intended or written to support the promotion or marketing of any of the transactions or matters it addresses.

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