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Use a minor’s trust to avoid ‘kiddie tax’ penalties

by on
in Small Business Tax,Small Business Tax Deduction Strategies

The “other” new tax law passed this year—the Tax Increase Prevention and Reconciliation Act (TIPRA)—has caused a great deal of grumbling among tax-savvy parents.

Reason: TIPRA generally extends the “kiddie tax” an extra four years for every child.

Strategy: Create a minor’s trust (also called a Section 2503(c) trust) for your kids or grandkids. With this type of trust, the IRS taxes all the income directly to the trust. So, the kiddie tax never comes into play!

A minor’s trust has a distinct advantage over the better-known custodial account because the trust can continue past the age of majority in the state where you live. Therefore, you don’t have to worry about children squandering the funds in their accounts.

Here’s the whole story: If you set aside funds for your children—say, to save for their college education—the kiddie tax often erodes the earnings.

This tax kicks in once a young child’s unearned income exceeds an annual threshold ($1,700 for 2006). The excess is taxed at the parents’ highest marginal tax rate, regardless of the income’s source.

Prior to 2006, the kiddie tax applied only to children under age 14. But now, it affects the earnings of children who won’t turn 18 by this year’s close.

So, instead of your child’s income being taxed at relatively low tax rates—as low as 10 percent—a large chunk of the income could be taxed at a rate as high as 35 percent (see box).

In comparison, the income in a custodial account is subject to the kiddie tax, even if it’s established under your state’s Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA).

Plus, the account is legally turned over to the child when he or she reaches age 18 or 21.

Extra benefit: You can structure a minor’s trust so that it automatically continues beyond the age of majority if your child doesn’t exercise a limited right to withdraw the funds. This exercise period can be as short as one month.

Any transfers to the trust are subject to gift tax, but that’s relatively easy to get around. Under the annual gift-tax exclusion, you can give each child or grandchild up to $12,000 a year without paying any gift tax.

Plus, the annual exclusion doubles for joint gifts by a married couple.

So, you and your spouse can transfer up to $24,000 a year to the trust gift-tax-free. If you do that five years in a row, you can transfer as much as $120,000 to the trust. And you can use this technique for every grandchild, if you choose.

This idea makes even more sense if your children or grandchildren are infants. Make the gifts right now; then sit back and watch the savings grow over time.

Tip: Beware of naming yourself as trustee. If you do, the funds will count toward your taxable estate should you die before the trust ends. Instead, you might name someone else, such as your tax pro, as trustee.

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