Limits on Family Income Shifting

The tax law imposes tough limits on a family’s ability to shift income for tax savings.

• Clifford Trusts are a thing of the past, as are Spousal Remainder Trusts. They are still legal, although the tax benefits have been largely withdrawn.
• Gifts of substantial income-producing assets to a child under age 19 (24 if a student) do not save taxes.
• It is much harder for a family to build up funds for major expenses, such as tuition.
However, tax advisors are still finding safe ways for families to shift income.

TAX REFORM CHANGES

1. The so-called “Kiddie Tax.” The investment income of a child under age 19 (24 is a student) will be taxed at the parent’s top tax rate if the investment income exceeds $1,800 a year (in 2008). The first $900 of investment income may be offset by the child’s standard deduction. The next $900 is taxed at the child’s tax rate. Any remaining unearned income over $1,800 is taxed at the parent’s top tax rate.

2. In 2008, the AMT exemption amount for a child subject to the “Kiddie Tax”, who has unearned income, is the lesser of (1) $33,750 or (2) the sum of the child’s earned income plus $6,400 (as indexed for 2008).

3. Rules for taxing the income from short term trusts. Income from assets in reversionary trusts (see below) will be taxed at the top tax rate of the person who set up the trust - the grantor. This provision wipes out the income-shifting benefit of Clifford Trusts and Spousal Remainder Trusts.

SAFE INCOME SHIFTING

Income-shifting techniques that may remain unaffected:

• U.S. Savings Bonds - an excellent investment vehicle for financing a child’s education. Savings bonds come with a built-in tax benefit that provides a way around the kiddie tax. Tax on the accrued interest is not due until the bonds are cashed in at maturity.
• The kiddie tax applies only for the period in which a child is under age 19. If you give a very young child savings bonds that do not mature until the child is 19 or older, the interest will be taxed at the child’s rate, not yours. The tax savings subsidize education expenses.
• Irrevocable trusts. The trust rules curtail the use of “reversionary” trusts; that is, trusts where the assets are returned after a period of years to the grantor or the spouse. Parents who have assets to spare should consider setting up irrevocable trusts for their children over age 18.
• If properly written up, irrevocable trusts will not conflict with the tax rules. Drawback: When you set up an irrevocable trust, you are not only giving away the income but also the assets that go into the trust.
• Wages: The kiddie tax applies only to investment income - dividends, interest, capital gains, etc. It does not apply to wages the child earns. A very popular income-shifting technique that has survived tax reform is hiring your children to work in your business. If you do this, however, be sure the child does real work for a reasonable wage.

OTHER SAFE INCOME SHIFTING TECHNIQUES

• Interest-free loans of under $10,000 that are not for the purpose of tax avoidance and are not used directly to buy income-producing assets.
• A leasing arrangement whereby children over age 19 own an office building or equipment that your business rents from them. These arrangements shift rental income to the children.

USING GROWTH

One way to beat the kiddie tax would be to transfer to children assets that produce little current income but will yield gains in the future when the children are over age 19. Examples: Real estate and long term growth stocks. However, there can be drawbacks to transferring these kinds of assets to a child:

• The differential in tax rates between a parent and a child is often not great enough to warrant putting real estate or stock in a child’s name.
• Depreciation deductions on business real estate are worth more to a high-bracket parent than to a low-bracket child.

SPLITTING INCOME WITH FAMILY

Tax advisors are frequently asked about the possibilities for lessening the tax bite by splitting income with family members or others.

The answer is that there are such income-sharing opportunities, but they do not consist merely of attributing income to somebody else. Income belongs to whoever earns it, so income splitting is more than just a reporting ploy; it involves actually turning over rights to the income along with control over what is to be done with it.

Thus, there is no tax-saving way to split income after the fact. Splitting can be arranged now for the current year and future years, but not for the year just ended; income from the past year and earlier is water over the dam.

A surprising fact to some is that there is only one income tax saving way to split income with your spouse and that is by filing a joint tax return. There is no income tax advantage in any other procedure for shifting income to husband or wife. As for splitting income with others, among the options available to you are the following:

Gifts. You can give up to $12,000 a year in 2008 (cash or income-producing property) to each donee you wish ($24,000 a year if your spouse agrees) without incurring gift tax. The advantage is that you transfer to the recipient the tax liability on future income the gift earns. If the recipient is a minor whose income, even after the gift, does not require the filing of an income tax return, file form 1087 to put the IRS on notice of the transfer.

Custodian Account. You can put assets in your child’s name in accordance with the state’s Gift to Minors Act, but making yourself the custodian could cause assets to become part of your taxable estate if you should die before the child reaches majority. In addition, you must turn complete control of the assets over to the minor at age 18 or 21; depending on the age of majority in your state.

Family Limited Partnership. A family limited partnership, with general and limited partnership interests divided among family members, is another method of shifting income. The transfer of ownership must be real, with an independent custodian appointed on behalf of minors. Incorporated and unincorporated businesses are other possible variations on this theme.

Interest-Free Loan. Congress has severely restricted the usefulness of interest-free loans to shift income. Now there are complicated rules for imputed interest if an interest-free or below-market loan is used for tax-avoidance. You should consult with your tax advisor before using one of these loans to shift income.

You may safely utilize small loans to children that do not represent an opportunity for them to earn a significant amount of interest on the proceeds. Regulations permit $1,000 of earnings, calculated on an interest assumption. Therefore, if the assumed interest rate is 11%, you could loan $9,000 to a child. The child’s earnings on this amount would be less than $1,200. However, if this was done early, the child’s earnings in a very low tax bracket will begin to amount up very attractively.

Family Employment. Another form of income shifting is putting members of the family on the company payroll. There is nothing in such an arrangement to cause trouble with the tax collector, as long as work is actually performed and the compensation is reasonable. Salary or wages in such cases are not allowed to accrue beyond two and a half months of the end of the tax year.

Support Problems. When splitting income with your minor children, you may risk losing them as dependents because you no longer provide more than half of their support. One way around this is to make sure all of what you contribute is used for purposes defined as support, while other income is used for nonsupport purposes.

Advance Gift Method. You may give to a child a single gift or a series of sums that will provide for their education. Investment earnings would be taxed in the child’s name and tax bracket, if the child has sufficient income to have a tax liability.

The disadvantage is that at age 18 the child will have control of the funds and could not be directed to spend them for education.

The “Kiddie Tax” places restrictions on the amount of income a child under age 19 (2008) can receive. Under this law, any “unearned” income received in excess of $1,800 will be taxed at the parent’s tax rate, regardless of the source. (The child is allowed a $900 exemption for unearned income, therefore, $900 of the $1,800 ceiling would be taxed at the child’s rate and any excess amounts will be taxed to the child but at the parents’ rate.

Avoid Retaining Control. If you do transfer assets to your child, be sure you do not share in the income they produce. This might be taxable income to you. Even using the income to provide a benefit to the child that is part of the support you are legally obligated to supply could make it taxable income to you.

In setting up any income-splitting program, it is essential that professional legal and accounting assistance be obtained. The IRS views all dealings among family members with grave suspicion, so extra care must be taken to insure that such transactions are genuine. Be explicit and properly document all correspondence.

Source: Tax Facts, National Underwriter Company

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