Year End Tax Planning

The latest wrinkle in the rules is tied to the recent law and a looming tax break for certain low-bracket taxpayers.

Let's quickly review the basics. Normally, income received by your child is taxable to the child at the prevailing tax rates. For most children, the income is taxed at an "ordinary income" rate no higher than 10 or 15 percent. Even better: If the child sells securities that qualify for preferential long-term capital gain treatment or he or she receives qualified dividends, the maximum tax rate for this investment income is only 5 percent in 2007. (High-income taxpayers may benefit from a maximum 15 percent tax rate.)

Best of all, the 5 percent rate is scheduled to drop all the way down to zero for 2008. That is not a misprint. Some low-bracket individuals will pay no tax whatsoever on long-term capital gain and qualified dividends next year.

Unfortunately, this is where the kiddie tax complicates matters. If a child under age 18 receives "unearned income" (including capital gains and dividends) above $1,700 in 2007, the excess is taxed at the top tax rate of the child's parents. (The dollar threshold will be increasing to $1,800 for 2008.) In other words, a portion of your child ‘s earnings could be taxed at a rate as high as 35 percent. If the threshold is exceeded, only unearned income in excess of the threshold gets taxed at your higher rates.

Prior to 2006, this onerous Kiddie Tax provision only applied to children under age 14.

The Small Business and Work Opportunity Tax Act, passed in May of this year, raises the bar again. Beginning in 2008, the kiddie tax will apply to any child under age 19, or a child who is a full-time student under age 24, if the child does not have earned income (from part-time job wages) exceeding half of his or her support. Thus, the kiddie tax could come back to haunt many families who thought they it had been banished from their existence. To recap:

• For 2007, the kiddie tax applies to a child who has not turned age 18 by December 31, 2007.
• For 2008, the kiddie tax applies to a child who has not turned age 19 by December 31, 2008, or a full-time student who has not turned age 24 by December 31, 2008, if the child does not have earned income totaling more than half of his support.

This tax law change also nips a clever tax idea in the bud. With the zero tax rate for capital gains fast approaching, some parents thought about transferring -- or did transfer -- income-producing assets to their low-bracket children. The plan was for the low-bracket children to sell off those assets next year and qualify for the zero percent capital gains tax rate.

But now sales of the assets in 2008 by your child could trigger the kiddie tax or increase it substantially.

Fast tax moves: You can still transfer assets to a child and arrange to have the child sell those assets before January 1, 2008. The tax on qualified capital gains will only be 5 percent -- not as desirable as zero percent, but still a pretty good deal. For instance, you could use stock sale proceeds to help pay for a 20-year-old's college tuition. Note that the gift tax exclusion allows you to give property valued at up to $12,000 to a recipient each year without any gift tax ramifications.

For this purpose, the length of your holding period can be added to your child's.

Of course, there are other economic factors at play here besides taxes, such as whether it's a good time to sell the stock and how assets will affect potential financial aid awards. Consider all the relevant factors before taking any action.