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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), many taxpayers abandoned income-shifting strategies involving their young children. TRA Section 101(a)'s enactment of the "kiddie tax," 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; most notably, Congress's penchant for deduction limits based on adjusted gross income (AGI) 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 (e.g., investment income) of certain minor children is taxed at the parents' rate, while the child's earned income 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 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 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 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
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 phaseout). Initially enacted as temporary revenue raisers, these phaseouts were made permanent by Revenue Reconciliation Act of 1993 (RRA '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 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
 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.


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) is limited by using the IRS 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.


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 The Tax Adviser aff'g affirming AFTR2d 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 DC District Court DRA Deficit Reduction Act of 1984 ERISA Employee Retirement Income

Security Act of 1974 ERTA 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 General Counsel Memorandum H. Rep. House Ways and Means Committee

Report IR Internal Revenue News Release IRB 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 Subchapter S Revision Act of 1982 Sup. Ct. Supreme Court TAM Technical Advice Memorandum TAMRA Technical and Miscellaneous

Revenue Act of 1988 TC Tax Court (regular decision) TC Memo Tax Court (memorandum decision) TD Treasury Decision TEFRA Tax Equity and Fiscal

Responsibility Act of 1982 TRA Tax Reform Act of 1986 USTC 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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Author:Gervais, Paul L., Jr.
Publication:The Tax Adviser
Date:Jun 1, 1995
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