Children as tax shelters.by Crain, John
Tax shelters may be defined as any operation that reduces taxes on current earnings. Past tax laws provided these opportunities by using child-related tax shelters. Following recent tax law changes, particularly TRA 86, the opportunities for reducing taxes by shifting income to children has become a more complex matter. With proper tax planning, however, child-related tax shelters can still provide certain substantial tax savings.
Many taxpayers have used a process known as income shifting. This technique focused on shifting income from parent to child in a lower tax bracket. Generally, prior to TRA 86, parents and grandparents could transfer income producing property to children to reduce taxes on the related income.
Goals of TRA 86 included: 1) closing many loopholes that enabled wealthy people to pay little or no federal income taxes; and 2) restoring a sense of fairness to the U.S. system of taxation. An April 17, 1989, Wall Street Journal article stated this about the tax law:
"Although the effects are uneven and
the full impact is uncertain, the
burdens are clearly more evenly
balanced, and among individuals, at least,
winners vastly outnumber losers." Whether we would agree with that characterization is a matter of personal experience.
Provisions of Current Tax Law Relating to Minors' Income
The first major provision of TRA 86 was the elimination of the double exemption for dependents. Under the old law parents could claim an exemption for each dependent child, and the child, if working on a part- time basis, could also claim an exemption on his or her own return. Under present law, if children are claimed as dependents on their parents' returns, they cannot claim the personal exemption on their own returns. Congress justified this change as ending a tax break that provided families with a double benefit.
Current law also requires parents to provide a social security number for each child of five years of age. Beginning with 1989 returns, this applies to children age two or older. A purpose of this requirement is to eliminate the use of fictitious names to receive pretended exemptions.
Another provision of TRA 86 relates to the "kiddie tax" on investment income. Earnings in excess of $1,000 from savings or other investments held by a child under age 14 will be taxed at the parents' marginal tax rate. Such investment income was previously taxed at the child's rate which was generally lower than the parents' rate. The child's rate was also changed to 15% in 1988, from 11% in 1986 and 1987. Intra-family transfers of income producing property can no longer be used to reduce income tax liability by shifting income from the parents' high marginal rate to a child's generally lower rate if the child is under age 14.
TRA 86 eliminated the use of Clifford trusts. These trusts were used to shift income to a lower-tax-bracket member who did not want to make an absolute transfer of the income producing property. The Clifford trusts were used primarily as a device to deduct the costs of private education. They were created for a 10 year period, and income was taxed at the child's rate. After 10 years, parents could reclaim the principal amount of the trust.
Parents would pay, and claim a deduction for interest on money borrowed from the trust. The trustee could then use the interest received to pay the educational expenses of the children. TRA 86 eliminated these procedures by requiring that all trusts created after March 1, 1986 be taxed at the rate of the person who established the trust. For trusts established before this date, income will be taxed at the child's rate. If the child is under age 14, however, unearned income in excess of $1,000 will be taxed at the parent's marginal rate.
Earned and Unearned Income
In 1986, dependents with unearned income were not required to file a return unless their income exceeded $1,080. Beginning in 1987, any individual who could be claimed as a dependent on another person's tax return or who had unearned income in excess of $500 must file a return. For earned income only, the threshold is $3,000. The $500 threshold applies when the child has only unearned income or both unearned and earned income. As a result, more parents will have to file returns for their children. Moreover, a parent to whom the "kiddie tax" applies must provide the parent's taxpayer identification number for inclusion on the child's return. Failure to do so may subject the parent to penalties.
Earned income is any amount received as pay for work done. A child's unearned income includes unearned income attributable to property transferred to the child, gifts from persons other than parents, and gifts made under the Uniform Gifts to Minors Act; it also includes unearned income derived from the child's earned income, such as interest on bank deposits.
Net unearned income (the amount taxed at the parents' marginal rate) is all of the child's unearned income, regardless of source, minus the sum of $500 and the greater of the $500 standard deduction or, if the child itemizes, the amount of the allowable deductions directly connected with production of unearned income.
The following are rules that apply to the taxation of children's income under age 14. The first $500 of the child's unearned income is not taxed at all since this amount is regarded as the child's standard deduction. The next $500 is taxed at the child's tax rate. Any earnings in excess of $1,000 will be taxed at the parent's marginal tax rate. Figure 1 provides examples of the computation of the tax liability for children with unearned income. Figure 2 provides examples for the computation of the child's tax liability where there is both earned and unearned income.
The Dependent Tax Care Credit
The growing tax burden on families is an issue that Congress is presently discussing. Currently the only relief to taxpayers with a number of children comes from the child and dependent care credit. This credit allows individuals to claim a tax credit for qualifying household and dependent care expenses incurred for the care of a qualifying individual.
The Dependent Care Tax Credit, commonly known as the child care tax credit is applied against the family's income tax liability and is based on a percentage of child care costs incurred by families for as much as $2,400 per child. The percentage used in calculating the credit varies with the parents' level of income. Taxpayers who have an adjusted gross income of $100,000 or less are allowed a credit based on 30%. The 30% credit is reduced by 1% for each $2,000 of adjusted gross income above $10,000 with the percentage remaining fixed at 20% for those with income over $28,000.
Tax Savings Strategies For Parents
There remain several tax saving strategies available to parents, including investments, trusts, employment of children in family businesses, and family partnerships.
There are many types of investments that parents may consider. Certain investments often serve as a means of deferring income until the child reaches age 14, and will be able to avoid the "kiddie" tax.
Investment income is typically treated in one of three ways: 1) taxed when received; 2) exempt from tax; or 3) taxed at a later date. Although tax-exempt investments may sound like the best option, this may not be the case, as they often carry lower rates of return. Some investments to consider include: U.S. savings bonds, tax exempt municipal bonds, life insurance, stocks, and appreciating property.
U.S. savings bonds can be an effective part of a tax-saving strategy. The Series EE bond is one of the most popular and practical investments. These may be purchased at half of their face value. These bonds allow minors to defer income until the bonds are redeemed or until the child elects to recognize the income. On maturity or redemption, the child collects the face value of the bond plus additional interest if rates have increased. Interest is calculated by subracting the price paid for the bond from the amount received on redemption. However, if bonds are redeemed prior to maturity, interest is based on the initial rate established when the bonds were purchased. This means that bonds redeemed prior to maturity will not earn additional interest when rates have increased after the bonds were purchased. Therefore deferring the interest until maturity seems to be the most profitable alternative. Caroline Strobel and Patricia Wilson, CPAs from South Carolina have noted that:
"By opting to defer reporting the
interest on the Series EE bonds, parents
can effectively shift the taxation of this
interest income to their children. If
the bonds are purchased under the
child's name and do not mature or are
not sold until after the child reaches
14 years of age, interest income will
be taxed at the child's lower rate."
The only drawback is that the reporting method selected when EE bonds are purchased (recognition or redemption), must be applied to these types of bonds purchased in the future.
An additional technique using Series EE bonds is for parents, starting in 1990, to buy the bonds and use the proceeds at maturity to pay for a child's college tuition. In such cases, the interest income on the bonds is exempt from federal income tax. This benefit, however, is phased out for taxpayers with income over $60,000.
Tax exempt bonds are qualifying obligations of state and local governments. Often these bonds yield less than taxable bonds with comparable risk. One strategy to pursue is to purchase such bonds and then hold them until the child turns 14. The bonds can be sold and the proceeds used to purchase investments with higher yields. Any gain from the sale will then be taxed at the child's rate instead of the parents'. Losses would not be desirable, however.
Life insurance is another way of deferring income until a child reaches age 14. Money placed into life insurance policies accumulates income on a tax deferred basis until the funds are withdrawn. The child would then pay taxes on the difference between the premiums and the amount withdrawn.
As a result, many universal and whole life policies are being promoted as a means to accumulate money for college.
Gifts of growth stocks and appreciating property under the Uniform Gifts to Minors Act provide an effective tool for transferring property to a child under age 14. By transferring stock or property to a child, there will be no tax consequences or any appreciation in value until the stock or property is sold. Upon such sale after the child turns 14, the tax on any capital gains will be at the child's rate. Stocks of companies with low dividend payout rates and high growth potential are the best choice for shifting income in this way. The risk is that the stock's value will decline rather than increase.
Transfers of other appreciating property are more complicated than transfers of growth stocks. There are two forms of such transfers: absolute and partial. In an absolute transfer the transferor gives the title and interest to the child forever. In a partial transfer, the transferor gives up title and interest for a specified period of time. It is important to remember what rights the donor is relinquishing. In deciding which property to transfer to children, the tax benefits must be carefully weighed against the cost of losing the outright ownership of the asset.
Trusts have become much less effective in lowering taxes since TRA 86. As noted earlier, it eliminated the use of Clifford trusts and imposed additional restrictions on all trusts.
Popularity in the past stemmed from the flexibility that trusts provided as income shifting tools. Besides their effectiveness in reducing parents' taxable income, they also provided a means of supervising children's investments. Today, however, trusts are much more complicated and costly to establish and maintain.
The simplest type of trust, the custodial trust, has now become the most popular type. Setting up a custodial trust is relatively easy. It is established by transferring an investment to any competent adult or trust company who acts for the child. Under the Uniform Gifts to Minors Act, each child can still receive up to $10,000 each year free of gift taxes.
Employing Children in a Family Business
By employing a child in a family business, the parent benefits not only from the services rendered, but also from the business deduction generated by the wages. The child's earnings as an employee are not subject to "kiddie" tax treatment because they are earned income. A child's wages are considered ordinary income, and therefore subject to the $3,000 standard deduction. This means that the first $3,000 a child earns is not taxed. The parent can deduct the wages from the taxable income of the business, and the child owes no taxes on his or her earnings up to the amount of the standard deduction.
If the parent cannot claim the child as a dependent, then the child must claim the personal exemption on his or her return. However, since most parents do supply over half of their child's support, they must claim the child as a dependent on their return.
Salaries, wages, and other compensation paid to children are deductible business expenses as long as the compensation: 1) is an ordinary and necessary business expense; 2) is reasonable in amount; 3) is based on actual services rendered; and 4) is actually paid or incurred. What constitutes ordinary and necessary expense? Tax-payers engaged in a trade or business may deduct, as a business expense, wages paid to their children for work performed in connection with that business. Payments for performing odd jobs around the house do not qualify. A child must be hired to do something that the parent would be willing to hire another person to do.
What constitutes reasonable compensation? Compensation to children is considered reasonable if the parent would hire a non-family employee and pay that person the same amount for the work performed. Reasonable compensation is an important issue in the employment of children; the IRS looks carefully at payments to relatives. Proper documentation and record keeping is crucial. The parent must maintain records for children as for any other employee. If audited, the burden of proof is on the parent.
There have been several cases where the IRS has questioned "reasonable compensation." For example, in Barrier TCM 1983-258, a physician employed his child who was under 12 years of age. He paid the child $11,000 for helping in his office and performing duties that included emptying trash, sorting mail, and answering telephones. The court found it hard to believe that an intelligent and educated professional would pay $11,000 for office services performed by a small child on a part time basis. The court held, accordingly, that the wages were not reasonable, and were not deductible. If the facts and circumstances do not support the taxpayer's position, the IRS could recharacterize the payment as a taxable gift or dividend and deny tax deductions for amounts exceeding reasonable compensation.
A family partnership can be a useful tool for shifting income and capital assets to younger-generation family members. In a family partnership the parents relinquish part of their ownership in a business to their children. Family partnerships are usually complicated organizations and their success depends on the type of business and how the child contributes to the business operations.
Making a child a partner in name only will be ineffective in reducing tax liability. The child must have an actual ownership interest in the partnership. Parents should carefully weigh the benefits versus the costs associated with creating a family partnership. Setting up such partnerships can be very costly. If the child is a minor, the parent may be required to hire another party to act as a partner in the child's behalf.
Parents planning to use their children in tax shelter planning should always take advantage of the $500 standard deduction; this can save taxes on any type of income. Two especially useful strategies for parents include investing money for children in Series EE U.S. savings bonds or employing children in a family business.
The Series EE bonds are flexible, easy to purchase, and provide good returns. If parents are in a position to employ children, that option should be strongly considered. A child benefits from the extra money earned, and the parents can benefit from the services performed. Figure 1 to 2 Omitted
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