Under legislation enacted in 2001, tax on capital gains for those in the lowest federal income tax bracket was substantially reduced, and had even been scheduled to go to a 0% tax effective in 2008. This opened the door to a very attractive tax-minimizing strategy: transfer appreciated capital assets to low-income children beyond the reach of the “kiddie tax” who would then sell the assets. The kiddie tax (as modified in 2006 – see our November 2006 Update) required children under age 18 to generally pay capital gains tax at their parents’ rate, but a child 18 or older and in the lowest federal income tax bracket could sell appreciated assets with very little tax on the gain.
A provision tucked into recent war funding legislation, however, effectively wipes out this capital gains tax “loophole” (discussed in our June 2005 Update). Starting in 2008, the kiddie tax will be further extended to children through age 18 (and up to age 24 if they are full-time students).
Because the new law only becomes effective starting in 2008, there is still time to make strategic transfers of appreciated assets to children over age 17. Federal capital gains tax rates are significantly lower (5%) for those in the lowest federal income tax bracket than for those in the highest bracket (15%). A transfer of appreciated assets to a child over 17 for sale in 2007 may still make sense.
Also, keep in mind that the new law does not eliminate the three-tiered structure of the kiddie tax. In 2007, the first $850 in capital gains, dividends, and interest is tax-free. The next $850 is taxed at the child’s federal income tax bracket rate, usually 5%. Anything above $1,700 is taxed at the parents’ presumably higher rate, usually the top rate of 15%. This means that individuals subject to the kiddie tax can benefit from the 0% and 5% capital gains rate for the lowest income earners starting in 2008, but only on capital gains up to $1,700 (the figure is inflation adjusted, so it may be higher in the coming years).
Let’s walk through an example to show the implications of transferring and selling appreciated assets this year versus next year. Assume “parents” own stock that they bought over a year ago for $10,000. The stock is now worth $20,000, reflecting a $10,000 appreciation. Also, assume that parents are in the highest tax bracket, subject to 15% federal capital gains tax, and “child” is in the lowest tax bracket, subject to 5% federal capital gains tax.
If parents sell the stock, they will incur a $1,500 long-term capital gains tax. 15% of $10,000 is $1,500.
If parents transfer the stock to an 18-year-old (or older) child in 2007 and the child sells the stock, the child will incur a $500 capital gains tax. The child’s capital gains are taxed entirely at her rate, because she is beyond the reach of the kiddie tax. 5% of $10,000 is $500.
If, in 2008, parents transfer the stock to a child who is under age 18 (or a full-time student under age 24) and the child sells the stock, the child will incur a $1,245 capital gains tax. The first $850 of gain will be tax-free. The next $850 will also be tax-free, as capital gains tax for the lowest earners will drop to 0% in 2008. The remaining amount above $1,700 will be taxed at the parents’ 15% rate, totaling $1,245.
As you can see, a transfer to, and sale by, a child not affected by the kiddie tax in 2007 would yield substantially less capital gains tax than in 2008, when the reach of the kiddie tax is extended. If you have a child who is (or before year-end will be) between the ages of 18 and 24, consider the tax-saving potential of having the child sell long-term capital gain assets before the end of 2007.
A few final notes: the expanded reach of the kiddie tax does not affect a child’s earned income, such as wages or tips from a summer job. Earned income is still taxed at the child’s rate. Also, the new kiddie tax rules do not affect 529 college-savings plans, which now have a revived attractiveness as investment vehicles to fund a child’s education. If you have any questions regarding the latest kiddie tax rules or planning strategies, please contact your tax attorneys or advisors.
