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Congress plays rough: Fight the new expansion of ‘kiddie tax’ law

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in Small Business Tax,Small Business Tax Deduction Strategies

Just when you thought it was safe to transfer funds to your children… .

The new tax law signed on May 25, 2007, may send shivers down your spine. Reason: For the second time in a year, Congress extended the dreaded “kiddie tax” reach. The change can short-circuit a capital gains tax break scheduled to take effect next year.

Strategy: Don’t do anything rash. If your plans have gone awry, you still have several options at your disposal.

Here’s the drill: Normally, the IRS taxes income at the tax rate of the person who receives it. However, under the kiddie tax, unearned income received by a child is taxable at the child’s parents’ top marginal tax rate to the extent it exceeds an annual threshold amount ($1,700 for 2007). Therefore, instead of being taxed at the lowest 10% or 15% rates, the effective tax rate on the excess income may be as high as 35%.

The tax rate for long-term capital gains and dividends is 15% for individuals in the higher tax brackets. But it’s only 5% for those in the regular 10% and 15% brackets. Even better: The rate drops from 5% to zero for 2008. With this tax break looming on the horizon, many parents started shifting investments to their low-bracket children.

Danger ahead: Prior to 2006, the kiddie-tax age limit was only 14. Once a child reached his or her 14th birthday, the tax no longer applied for that year and subsequent years. But the Tax Increase Prevention and Reconciliation Act of 2005 (signed in 2006) raised the bar to age 18. So you may have arranged for your children to hold onto stocks, mutual funds and other assets in custodial accounts a little longer.

The new law throws another monkey wrench in the works. Starting in 2008, it hikes the age threshold to age 19, or 24 for full-time students. Those higher age limits apply if the child doesn’t have earned income in excess of half of his or her annual support.

If you’re in a quandary as to what to do now, consider the following options:
  • Have your low-income child sell investment assets this year and, if possible, benefit from the 5% capital gains rate.

  • Wait to have your child sell assets when he or she reaches the higher kiddie-tax age or has earned income in excess of 50% of his or her support.

  • Instead of shifting assets to your child, move them into an elderly parent’s account. When the parent sells the assets, the capital gain will be taxed at only 5% (or 0% for 2008) for those in the regular 10% or 15% brackets, thereby lowering the overall family tax bill.

  • Use other tax strategies to minimize the kiddie-tax impact (see related article).
You can’t make those decisions in a vacuum. Example: Having your child keep equity investments longer not only extends market-risk exposure, but it may adversely affect college financial aid.

Tip: Seek guidance from a financial pro. He or she can help develop a plan that takes all factors into account.

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