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Congress Expands Application of "Kiddie Tax" for 2008

03.31.2008

Clients who have children with investment income should be aware that legislation recently enacted by Congress has expanded the application of the “kiddie tax” for 2008. As outlined below, the “kiddie tax” will be imposed on children as old as 23 years of age who receive investment income, starting in 2008.

The “kiddie tax” was originally enacted in 1986 to address a congressional concern that affluent parents were transferring income-producing assets (either directly or indirectly via trusts) to their children in order to shift the income from these assets from the parents (who typically were being taxed at the highest marginal tax bracket) to their children (who were generally being taxed at a much lower tax rate). The “kiddie tax” rules initially caused all investment income of minor children under age 14 over a modest base amount (currently $1,700) to be taxed at their parents’ highest marginal rate. In 2006, the “kiddie tax” was extended to children under the age of 18.

The new “kiddie tax” rules, enacted last year, now require, for the 2008 tax year and beyond, that a substantial number of children as old as age 23 who have investment income will have this income subjected to their parents’ highest marginal income tax rate, instead of the child’s generally lower marginal tax bracket. The new rules are now much more complex in that they create three separate classes of children who are subject to this tax.

The first class consists of all those children who were already subject to this tax prior to the 2007 changes. These children are those under age 18 who have investment income in excess of $1,700 in a tax year and do not file a joint return (i.e., are not married).

The second class (a new class), added by the 2007 legislation, is comprised of those children who have attained age 18 by December 31, have annual investment income in excess of $1,700, do not file a joint return, and who do not have earned income (i.e., self-employment income or wages or salary income) that exceeds 50% of the child’s own support.

Finally, the third new group or class of children, also added by this 2007 tax act, now subject to the “kiddie tax” rules are those children who are age 19 through 23 on December 31, who have annual investment income in excess of $1,700, do not file a joint return, are full-time students for at least five months of the calendar year, and who do not have earned income that exceeds 50% of the child’s own support.

From a planning standpoint, in order to ameliorate the application of these new tax rules, clients who have children age 23 or younger may want to consider the following options.

Parents who are making gifts to their children for estate planning or other reasons should consider making gifts of assets that are not income-producing until the child reaches age 24 or completes his or her college education.
A child should delay the sale of appreciated property until after he or she has attained age 24 or completed college.
Parents who desire to make gifts of assets to their children under age 24 may want to consider making gifts of assets that generate tax-free or tax-deferred income, such as municipal bonds, Series E Savings Bonds, insurance policies, and deferred annuities.
Parents may want to consider using a Section 529 Plan as the vehicle to make gifts to their younger children. A gift to a 529 college savings plan is not subject to the “kiddie tax” since the income generated from the assets in the plan is tax-free to the child if used for the child’s higher education.
In conclusion, clients with children under age 24 who have investment income will need to take into consideration these new income tax rules as a part of their estate and income tax planning for 2008.
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