A common tax strategy among high wealth individuals is to shift income to their children where it will be taxed at a lower tax rate. If the child works in 
the taxpayer’s business, this can be done by putting the child on payroll. The taxpayer can deduct the payroll (as long as it is reasonable considering the services the child provides) and the payroll is taxed as income at the child’s lower tax rate.
Another technique is to shift income producing assets to the child. The intent is to have the investment income taxed at the child’s lower tax rate. However, the IRS is wise to this technique and if the child’s investment income exceeds $2,000, the excess investment income is taxed at the parents’ higher tax rate. This rule is known as the kiddie tax.
When Does the Kiddie Tax Apply?
The kiddie tax applies if:
(1) the child’s unearned income is more than $2,000
(2) the child meets one of the following age requirements
- the child is under age 18 at the end of the year
- the child is age 18 at the end of the year and the child’s earned income did not exceed one-half of the child’s own support for the year
- the child is a full time student who is under age 24 at the end of the year and the child’s earned income did not exceed one half of the child’s own support for the year (excluding scholarships)
(3) at least one of the child’s parents is alive at the end of the year
(4) the child is required to file a tax return for the year
(5) the child does not file a joint return for the year
It is important to keep in mind that the kiddie tax only applies to unearned income, earned income such as wages is not subject to this provision.
Example: Joan, who is in the 25% tax bracket, transfers investments to her child, Tommy (age 15). Tommy has interest income of $3,200 in 2014. The first $1,000 is sheltered by his standard deduction. The next $1,000 is taxed at his tax rate of 10%. The remaining $1,200 of interest income is taxed at Joan’s 25% tax rate.
How to Avoid the Kiddie Tax
It is possible to minimize the kiddie tax by shifting to children investment assets that do not generate current taxable income, such as:
Municipal Bonds: These investments are not subject to federal tax and therefore escape the kiddie tax.
Growth Oriented Investments: An example would be growth stocks or mutual funds that do not pay large dividends to shareholders. Most of the income is capital appreciation that is recognized for tax purposes when the investment is ultimately sold. If the child can hold the growth stocks past age 23 (if the child is a full time student), the stocks can be sold without being subject to the kiddie tax.
U.S. Discount Bonds: These bonds are issued at a discount and do not generate taxable interest income until they are redeemed. The bonds can be redeemed after the child is no longer subject to the kiddie tax.
If you have questions about how this applies to you, please contact us.
Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.