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4 ways to cut the ‘kiddie tax’ down to size

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in Small Business Tax,Small Business Tax Deduction Strategies

For parents and grandparents, a basic tax strategy is to transfer income-producing assets (e.g., cash, stock, real estate) to the young ones. The subsequent income is generally taxed at the child’s low tax rate, rather than the elder’s higher one.

But taxpayers often pay a price for this income-shifting tactic.

Advice: Beware of the “kiddie tax.” If it applies, some of the child’s income will be taxed at a higher tax rate than the child’s basic rate, which defeats your original tax intentions.

Fortunately, you can reduce the kiddie-tax impact—or even sidestep it entirely— with some smart planning.

Basics of the kiddie tax

Income is normally taxed at the rate of the person who receives it. But unearned income (e.g., from investments) received by a child under age 14 is taxable at the parent’s top marginal tax rate once that income exceeds a certain annual threshold ($1,700 for 2006, up from $1,600 in 2005). The first $850 is tax free; the next $850 is taxed at 10 percent. Income above the $1,700 threshold is taxed at the parent’s top marginal rate, which is often much higher.

In other words, instead of the child’s income being taxed at 10 percent, the effective rate on income above the threshold may run as high as 35 percent. This sounds painful, but it’s not as bad as you think. Consider these points:

• The tax applies only to children under 14. In the year your child hits 14, you’re off the hook.

• The tax applies only to unearned income, such as capital gains, dividends and interest. Any income your child earns from jobs or self-employment is exempt from the kiddie-tax rules.

• Even if income is generated by money or assets from gifts made to the child by high-bracket individuals, there’s no kiddie tax below the threshold.

Now that you know the lay of the land, here are four smart tax strategies for beating the kiddie tax:

1. Monitor your child’s investment income. If you’re careful to stay below the $1,700 fault line, you won’t face any kiddie-tax problems. For instance, you might invest in CDs for the child that won’t mature until 2007. This technique works especially well for children who will turn 14 next year.

2. Emphasize tax-deferred investments. Shift more of your child’s portfolio into long-range vehicles such as growth stock, rather than investments that produce current income. Similarly, if you buy U.S. Savings Bonds in the child’s name, he or she doesn’t have to pay any current tax (see box below).

3. Switch some investment dollars into munis. Generally, there are no federal tax consequences for interest from municipal bonds or municipal bond funds. The income received is 100 percent tax free. So, if your child invests in munis, it won’t upset the apple cart.

4. Put your child on the company payroll. Since wages are earned income, the kiddie tax doesn’t apply. Assuming the child is paid a reasonable amount for the services performed, the business can deduct his or her salary. The Tax Court has even approved a work-for-pay arrangement for a nine-year-old.

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