Minimizing AGI-based deduction limits by shifting family income: big savings possible despite the kiddie tax.After the enactment of the Tax Reform Act of 1986 (TRA TRA Training TRA Transfer TRA Transition TRA Tennessee Regulatory Authority TRA Telecommunications Regulatory Authority (Oman) TRA Tax Reform Act (1976, 1984, or 1986) TRA Teachers Retirement Association ), many taxpayers abandoned income-shifting strategies involving their young children. TRA Section 101(a)'s enactment of the "kiddie tax Kiddie Tax A tax on children under 14 who earn income over $1,200. The extra income is taxed at the guardian's rate. Notes: Since children under 14 can not legally work, this income usually results from dividends or interest from bonds. ," combined with lower marginal tax rates, negated the remarkable tax savings possible before the TRA. However, recent tax law changes have restored some benefits of income shifting Income Shifting A strategy of moving a person's income from a high income bracket or tax rate to a lower one. Notes: One popular form of income shifting is applying some of a person's income to their child. See also: Income Tax, Tax Table ; most notably, Congress's penchant for deduction limits based on adjusted gross income (AGI (Artificial General Intelligence) A machine intelligence that resembles that of a human being. Considered impossible by many, most artificial intelligence (AI) research, projects and products deal with specific applications such as industrial robots, playing chess, ) floors and phaseouts requires a closer look at family income-shifting techniques. This article examines the kiddie tax effect on AGI-based phaseouts and floors and illustrates how family income shifting to children under age 14 may still achieve significant tax savings. The Kiddie Tax Under Sec. 1(g), unearned income Unearned Income Any income that comes from investments and other sources unrelated to employment services. Notes: Examples of unearned income include interest from a savings account, bond interest, tips, alimony, and dividends from stock. (e.g., investment income) of certain minor children is taxed at the parents' rate, while the child's earned income Sources of money derived from the labor, professional service, or entrepreneurship of an individual taxpayer as opposed to funds generated by investments, dividends, and interest. is taxed at the child's rate. Specifically, a child under age 14 at the end of 1995, with at least one living parent, is subject to kiddie tax if he recognizes unearned income over $1,300.(1) The tax imposed is the greater of - the tax on all of the child's income at the child's rate, or - the sum of the tax imposed at the child's rate on the child's taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. as reduced by his "net unearned income," plus the child's share of the "allocable parental tax."(2) * Net unearned income and allocable parental tax Sec. 1(g)(4)(A) provides that net unearned income is the excess of the portion of the child's AGI for the year that is not earned income over the sum of (1) the standard deduction The name given to a fixed amount of money that may be subtracted from the adjusted gross income of a taxpayer who does not itemize certain living expenses for Income Tax purposes. available to certain dependents under Sec. 63(c)(5)(A) (for 1995, $650), plus (2) the greater of (a) $650 or (b) the child's allowable itemized deductions directly connected to unearned income. Sec. 1(g)(3)(A) provides generally that allocable parental tax is the excess of the tax that would be imposed if the parents' taxable income included the child's net unearned income, over the parents' actual tax liability. Temp. Regs. Sec. 1.1(i)-1T, Q&A-14 states that parents with more than one child subject to the kiddie tax must increase their income by the unearned income of all their children subject to the tax. Each child is apportioned ap·por·tion tr.v. ap·por·tioned, ap·por·tion·ing, ap·por·tions To divide and assign according to a plan; allot: "The tendency persists to apportion blame as suits the circumstances" a share of the allocable parental tax based on the ratio of the child's unearned income to the total unearned income. Example 1: H and W file jointly in 1995, reporting $70,000 of taxable income. Their two children, B and S, are under age 14 and have net unearned income of $3,000 and $1,000, respectively. For 1995, H and W's allocable parental tax is:
Parents' taxable income 70,000
Children's net unearned income 4,000
74,000
Tax at parents' rate 15,923
Tax on parents' taxable income 14,803
Allocable parental tax $ 1,120
Allocation to B: $3,000/$4,000 x $1,120 = $840 Allocation to S: $1,000/$4,000 x $1,120 = $280 Floors and Phaseouts The Code is replete with limits on AGI-based deductions and exclusions (e.g., the Sec. 68 limit on itemized deductions and Sec. 151(d)(3) personal exemption Personal exemption Amount of money a taxpayer can exclude from personal income for each member of the household in calculation of a tax obligation. personal exemption See exemption. phaseout phase·out n. A gradual discontinuation. ). Initially enacted as temporary revenue raisers, these phaseouts were made permanent by Revenue Reconciliation Act of 1993 (RRA RRA Registered Record Administrator. '93) Sections 13204 and 13205. Other limits include: 1. The phaseout of the $25,000 passive loss allowance (Sec. 469(i)). 2. The 7.5% AGI floor for medical expenses (Sec. 213(a)). 3. The 2% phaseout of miscellaneous itemized deductions (Sec. 67(a)). 4. The 10% floor for casualty losses (Sec. 165). 5. The individual retirement account deduction phaseout (Sec. 219(g)). 6. The phaseout of education savings bond Savings bond A government bond issued in face value denominations from $50 to $10,000, with local and state tax-free interest and semiannually adjusted interest rates. savings bond A nonmarketable security issued by the U.S. interest (Sec. 135(b)(2)). Most AGI-based limits negatively affect higher incomes. Clearly, taxpayers subject to these limits should consider strategies designed to reduce AGI. Kiddie Tax Effects Under Temp. Regs. Sec. 1.1(i)-1T, Q&A-21, AGI-based phaseouts, limits and floors are not taken into account in calculating allocable parental tax. For example, although amounts allowable to a parent as a medical expense, rental real estate loss or miscellaneous itemized deduction are affected by the parents' AGI, the allowed amount of these deductions does not change as a result of the kiddie tax. At first glance, Temp. Regs. Sec. 1.1(i)-1T appears to require giving full effect to the personal exemption phaseout when computing allocable parental tax. However, closer scrutiny reveals that this regulation refers to the pre-Revenue Reconciliation Act of 1990 (RRA '90) Sec. 1(g) 15% rate and personal exemption phaseouts.(3) The pre-RRA '90 Sec. 1(g) personal exemption phaseout was determined based on taxable income.(4) The Sec. 151(d) personal exemption phaseout created by RRA '90 Section 11104(a) (and made permanent by RRA '93 Section 13205) is AGI-based.(5) Thus, it falls within the same category as other AGI-based phaseouts addressed in Temp. Regs. Sec. 1.1(i)-1T and should not be taken into account when computing allocable parental tax. Parents still can maximize the value of their itemized deductions and other AGI-based deductions and exclusions by shifting income to children (including those subject to the kiddie tax). Example 2: Parents H and W file jointly, claiming their three children (all under age 14) as dependents. In 1995, H and W's AGI is $300,000. Their state has no income tax and they rent their home. Their $6,550 standard deduction exceeds itemized deductions. Shifting $10,000 of income to each child saves the family $2,242.
With income shift of
Without shift $10,000 per child
Parents Parents 3 children
Wages, salaries $220,000 $220,000 $ 0
interest and dividends 80,000 50,000 30,000
AGI 300,000 270,000 30,000
Standard deduction (6,550) (6,550) (1,950)
Personal exemptions 0 (12,500) 0
Taxable income 293,450 260,950 28,050
Tax 91,895 79,025 10,628(*) AMT 0 0 0 Total family tax $ 91,895 $89,653 (*) ($1,950 x 0.15) + ($26,100 x 0.396). Parents subject to several AGI-based limits may also achieve meaningful savings. Example 3: Parents H and W file jointly, claiming their three children (all under age 14) as dependents. In 1995, H and W's AGI is $230,000. Itemized deductions subject to AGI floors include $18,000 of medical expenses and $9,500 of employee business expenses. Shifting $10,000 of income to each child saves the family $3,541.
With income shift of
Without shift $10, 000 per child
Parents Parents 3 children
Wages, salaries 170'000 $170,000 $ 0
Interest and dividends 60,000 30,000 30,000
AGI 230,000 200,000 30,000
Itemized deductions:
medical expenses
> 7.5% AGI (750) (3,000) 0
taxes (12,000) (12,000) 0
mortgage interest (14,000) (114,000) 0
miscellaneous
deductions > 2% AGI (4,900) (5,500) 0
itemized deduction
phaseout 3,459 2,559
Standard deduction 0 0 (1,950)
Personal exemptions (6,500) (9,500) 0
Taxable income 195,309 158,559 28,050
Tax 55,234 42,004 9,689(*) AMT 0 0 0 Total family tax $ 55,234 $51,693 (*) ($1,950 x 0.15) + ($26,100 x 0.36). Parents subject to the phaseout of the Sec. 469(i) $25,000 passive loss allowance for rental real estate may also benefit from shifting income, especially if several AGI-based limits apply. Although the tax savings has been diminished by the kiddie tax, it is still substantial. Example 4: Parents H and W file jointly, claiming their three children (all under age 14) as dependents. In addition to wages, interest and dividends, H and W have a $15,000 active participation real estate loss and $60,000 of passthrough income from their S corporation. Itemized deductions subject to AGI phaseouts include $15,000 of medical expenses and $4,850 of employee business expenses. Shifting $10,000 of income to each child saves the family $6,904. [TABULAR DATA OMITTED] Including Child's Income on Parents' Return Sec. 1(g)(7) provides an election for a parent to include unearned income of a child on his own return under certain conditions. The child's gross income must consist solely of interest and dividends and be between $500 and $5,000. Although administratively convenient, the election eliminates the AGI-based deduction strategies discussed above, and may substantially increase the family's combined tax liability. If the parent makes the election (on Form 8814, Parent's Election To Report Child's Interest and Dividends), the child's income in excess of $1,000 is included in the parents' AGI (effectively reducing the parents' AGI-based deductions), and the lesser of (1) $75 or (2) 15% of the excess of the gross income of the child over $500 is included as additional tax on the parents' return. Alternative Minimum Tax Form 6251, Alternative Minimum Tax - Individuals, must be filed for a child under age 14 if the child's alternative minimum tax (AMT See vPro. ) is limited by using the IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. worksheet for Form 6251, Line 28, or if Line 22 is more than $1,000 plus the child's earned income. Care must be taken not to shift income so as to subject the child to the AMT. Conclusion The kiddie tax significantly reduced the benefits of shifting income to children under age 14. However, the proliferation of AGI-based deduction limits creates situations in which income shifting to such children remains beneficial, particularly for parents subject to multiple AGI-based limits. Defeating the rental real estate loss phaseout using income shifting provides substantial tax savings, especially if other AGI-based limits apply. These benefits are likely to increase as Congress continues to raise revenue by imposing floors and phaseouts. The opportunity for providing significant savings to clients by minimizing AGI should appeal to all tax practitioners. Using family income shifting as an "AGI management" tool should not be overlooked, even when the kiddie tax applies. Finally, practitioners should not hastily elect to report a child's income on the parents' return just for the sake of convenience. The election's effect on AGI-based limits must be analyzed. Abbreviations Commonly Used in The Tax Adviser TTA TTA Telecommunications Technology Association (Korea) TTA Teacher Training Agency (UK) TTA Triangle Transit Authority (Raleigh/Chapel Hill/Durham, North Carolina, USA) The Tax Adviser aff'g affirming AFTR AFTR American Federal Tax Reports (Prentice-Hall) AFTR Americans For Tax Reform AFTR Air Force Training Ribbon AFTR Air Force Training Record AFTR atrophy, fasciculation, tremor, rigidity AFTR Atomic Frequency Time Reference 2d American Federal Tax Reports, second series (Research Institute of America) Ann. IRS Announcements CB Cumulative Bulletin Cir. Court of Appeals Cl.Ct. Claims Court COBRA Consolidated Omnibus Budget Reconciliation Act of 1985 Cong. Rec. Congressional Record A daily publication of the federal government that details the legislative proceedings of Congress. The Congressional Record began in 1873 and, in 1947, a feature called The Daily Digest was added to briefly highlight the daily legislative activities of each House, DC District Court DRA DRA Delta Regional Authority DRA Developmental Reading Assessment (educational test) DRA Division of Ratepayer Advocates (California) DRA Data Research Associates DRA Directory and Resource Administrator Deficit Reduction Act of 1984 ERISA See Employee Retirement Income Security Act. ERISA See Employee Retirement Income Security Act (ERISA). Employee Retirement Income Security Act of 1974 ERTA ERTA Economic Recovery Tax Act (of 1981) ERTA Economic Recovery Tax Act of 1981 ERTA European Recorder Teachers Association (UK) ERTA Ethiopian Radio and Television Agency ERTA Earth Riders Trails Association Economic Recovery Tax Act of 1981 Fed. Reg. Federal Register F2d Federal Reports, second series F3d Federal Reports, third series F Supp Federal Supplement GCM GCM General Circulation Model GCM Global Climate Model GCM General Court-Martial GCM Galois/Counter Mode (cryptography) GCM Geriatric Care Managers GCM Global Circulation Model GCM Good Conduct Medal General Counsel Memorandum H. Rep. House Ways and Means WAYS AND MEANS. In legislative assemblies there is usually appointed a committee whose duties are to inquire into, and propose to the house, the ways and means to be adopted to raise funds for the use of the government. This body is called the committee of ways and means. Committee Report IR Internal Revenue News Release IRB IRB See: Industrial Revenue Bond Internal Revenue Bulletin PL Public Law Regs. Sec. Treasury Regulation Rev. Proc. Revenue Procedure Rev. Rul. Revenue Ruling rev'g reversing RRA Revenue Reconciliation Act of 1993 Sec. Section (refers to the Internal Revenue Code of 1986 unless otherwise indicated) S. Rep. Senate Finance Committee Report SSRA SSRA Swedish Street Rod Association SSRA Shadow Strategic Rail Authority (UK) SSRA Singapore Squash Rackets Association SSRA System Safety Risk Assessment SSRA Scottish Smallbore Rifle Association SSRA Seattle Squash Racquets Association Subchapter S Subchapter S IRS regulation that gives a corporation with 35 or fewer shareholders the option of being taxed as a partnership to escape corporate income taxes. Revision Act of 1982 Sup. Ct. Supreme Court TAM Technical Advice Memorandum TAMRA TAMRA Technical And Miscellaneous Revenue Act of 1988 TAMRA Tetramethyl-6-Carboxyrhodamine (dye) Technical and Miscellaneous Revenue Act of 1988 TC Tax Court (regular decision) TC Memo Tax Court (memorandum decision A court's decision that gives the ruling (what it decides and orders done), but no opinion (reasons for the decision). A memorandum decision is not subject to appeal by the dissatisfied party. ) TD Treasury Decision TEFRA TEFRA (Tax Equity and Fiscal Responsibility Act of 1983) The law requiring federal income tax withholding on payments of dividend and interest to accounts without a certified tax identification number on file. See: W-9. Tax Equity and Fiscal Responsibility Act of 1982 TRA Tax Reform Act of 1986 USTC USTC University of Science and Technology of China USTC United States Tax Cases (Commerce Clearing House) USTC United States Transportation Command (see USTRANSCOM) United States Tax Cases (Commerce Clearing House) (1) Sec. 1(g)(2); see Temp. Regs. Sec. 1.1(i)-1T, Q&A-1 and -2; Rev. Proc. 94-72, IRB 1994-50, 14. (2) Sec. 1(g)(1); Temp. Regs. Sec. 1.1(i)-1T, Q&A-3. (3) See Temp. Regs. Sec. 1.1(i)-1T, Q&A-20. RRA '90 Section 11101(b)(1) struck Sec. 1(g) and Section 11101(d)(2) recodified Sec. 1(i) as Sec. 1(g). (4) Pre-RRA '90 Sec. 1(g)(1)(A). (5) See Sec. 151(d)(3)(A). |
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