Congress closes child tax loophole
A new tax law signed by President Bush further tightens the screws on wealthy parents who make gifts to a child in order to take advantage of a lower tax rate on children's investment income.
The law marks the second time in just over a year that Washington has extended the reach of the so-called kiddie tax, which subjects a child's income to a parents' higher tax rate.
What prompted Congress to further expand the kiddie tax were reports that some wealthy parents were planning to take advantage of a tax-law change designed for low-income people that will be effective next year. By extending the reach of the kiddie tax, Congress effectively eliminated many of the benefits of this strategy.
But the changes to the kiddie tax could affect many other parents who have made gifts of stock and other securities to a child.
Under current law, investment income above a certain level (generally $1,700 for 2007) for a child 17 years old or younger typically is subject to the parents' tax rates, assuming the parents' rates are higher than the child's. That is still the law for this year. (Before the law was changed last year, the kiddie tax applied only to children younger than 14.)
Under the new law, the age limit will increase starting next year to children who are 18, or under 24 if the child is a full-time student. This expanded provision won't apply to some children with paid jobs. A congressional summary says the expanded provision applies "only to children whose earned income does not exceed one-half of the amount of their support." Even so, this new law "is going to affect a lot of people," warns Ed Slott, a New York CPA.
Congressional staffers estimate the expanded kiddie-tax provision will raise more than $1.4 billion over a decade.
The new law could give a boost to 529 college-savings plans, because investments in these accounts aren't subject to the kiddie tax. Tax advisers also say wealthy parents might invest a child's money in investments that generate little or no taxable income, such as municipal bonds.
The tax-saving strategy that touched off the latest law change, which was outlined in this column on Jan. 17, involved people in high tax brackets transferring ownership of large amounts of stock, mutual-fund shares and other assets to children in lower tax brackets. Under current law, the top tax rate on long-term capital gains and most corporate dividends this year generally is 15 percent. But for taxpayers whose income puts them in the two lowest ordinary income brackets (10 percent and 15 percent), the rate is only 5 percent this year - and zero next year. For people in higher brackets, the top long-term capital-gains rate on securities sales is to remain 15 percent next year, as is the rate on most types of dividends.
Anticipating this change, some investment advisers had been suggesting that high-income family members consider making gifts of securities that have gone up in value over the years to low-income family members, who could then sell those securities, tax-free, next year. The new law doesn't affect transfers to elderly parents or other relatives.
Among those affected by the new law is Nadine Gordon Lee, who earlier this year said she and her husband were planning to take advantage of the coming 0 percent rate next year to help fund college tuition costs. Lee, president of Prosper Advisors LLC, an Armonk, N.Y., wealth-management firm, says she and her husband had begun transferring shares of equity-based mutual funds, purchased at a lower cost, to their two sons, now 16 and 19.
"The new law puts a complete halt to the original plan for the younger son," which would have enabled him to begin selling the shares in the calendar year he turns 18 at the zero capital-gains tax rate, Lee says. But the 2008 effective date enables their older son, who is a full-time college student, "to sell shares this year and realize long-term capital gains at his lower income bracket tax rate of 5 percent," she says.
As Lee's case illustrates, transfers to some children and other family members may still be a good idea for this year. After all, the new legislation won't be effective until next year.
What else can taxpayers do?
One tip is to put a child's money in investments that generate little or no taxable income, says Richard Pon, a CPA with Lautze & Lautze, a San Francisco accounting and financial advisory firm. For instance, a child's funds could be invested in growth-oriented stocks or mutual funds that produce little or no current income; tax-exempt municipal bonds or municipal-bond funds; land expected to appreciate in value; closely held family business stock that pays low or no cash dividends; or U.S. series EE savings bonds for which you can defer reporting interest income.
To help with college tuition, consider setting up a 529 college-savings plan. Contributions are made with after-tax dollars, but the money "comes out tax free for college, and therefore would not be reported for income tax purposes," says Joseph Hurley, founder and CEO of Savingforcollege.com, a Web site providing independent information on 529 plans.
But trust-fund babies need to watch out. Income generated by a trust for which a child is the beneficiary may be subject to the kiddie tax, depending on how the trust was set up.
And before making sizable gifts to children or other family members, keep in mind that those gifts may backfire in some cases. Gifts could make a student ineligible for college financial aid, for example. Or they could make a senior's Social Security benefits subject to tax, or increase the tax on those benefits.
Thus, consider getting advice from tax and financial planners before making gifts. Also ask about any gift-tax or estate-tax consequences. You can give away as much as $12,000 this year to anyone you want - and to each of as many people as you wish - without any tax considerations. You don't even have to report your gift.
The new tax law includes other provisions, including tax relief for small businesses. It increases the maximum amount that many small businesses may choose to deduct for purchases of equipment, machinery and items in the year those items are purchased and used, instead of having to spread those costs over several years. This is often referred to as "Section 179 expensing," which refers to an Internal Revenue Code section.
Under the new legislation, the maximum amount that may be expensed for 2007 rises to $125,000 from $112,000. The new measure also raises this provision's phase-out threshold to $450,000 from $400,000 under current law.
Both the phase-out level and the expensing level are indexed for inflation through 2010, according to a congressional summary.