The Small Business and Work Opportunity Tax Act of 2007, signed into law on May 25, 2007, raised the age limit for application of the "kiddie tax" to all children under age 19 (previously age 18) and to students under age 24, effective for tax years beginning after May 25, 2007. Just last year, the "kiddie tax" age limit was raised from under age 14 to under age 18. There is an exception to these new age limits. If the earned income of an individual over age 17 exceeds half of his/her support, the "kiddie tax" does not apply. Scholarships are not considered in this test.
The "kiddie tax" refers to the manner in which unearned income is taxed for children. In 2007, the first $850 of unearned income is tax free, the second $850 is taxed at the child's marginal tax rate, and any remaining unearned income is taxed at the parents' marginal tax rate. Once the individual exceeds the age limits, all unearned income is taxed as his/her marginal tax rate.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
This change effectively eliminated a common college funding technique of gifting appreciated assets to the child as he/she approaches college age and then having the child sell the assets to take advantage of lower capital gains tax rates (5% if the child is in the 10% or 15% tax bracket, instead of 15%). That technique would have been even more attractive from 2008 to 2010, when the long-term capital gains tax rate would be 0% for taxpayers in the 10% or 15% tax bracket. (Note that the gift tax consequences of employing this technique would need to be weighed against the potential capital gains tax savings.)
Since the provision will not apply until 2008 for most taxpayers, students under age 24 may want to sell assets in 2007 to take advantage of the 5% capital gains tax rate. Alternatively, students may want to wait until age 24 to sell the assets. Of course, if the student has earned income sufficient to put him/her in a higher tax bracket, the 15% capital gains tax rate would have to be paid anyway. Note that the capital gains tax rate is scheduled to increase from 15% to 20% after 2010, unless further legislation is passed.
To minimize the effects of this new provision, taxpayers who are saving for a child's college education may want to invest the child's assets in section 529 plans or Coverdell education savings accounts, which provide tax-free distributions as long as the funds are used for qualified education expenses.
Taxpayers who own a business may want to employ their children, especially those in the 14 to 24 age group, since earned income is not subject to the "kiddie tax" rules and is taxed at the child's marginal tax rate. There is added incentive to do so for students over age 17, because the "kiddie tax" rules won't apply for that year if the individual's earned income is more than half of his/her support. Of course, the children must actually work to earn their salaries; otherwise, the taxpayers could be engaging in tax fraud.
Please call if you'd like to discuss this in more detail.