Family income shifting
By Luis I. Ingles III, CPA • Bankrate.com

Taxpayers who properly shift income will benefit by decreasing both their tax liability and their adjusted gross income. For instance, shifting an appreciated asset increases the savings from this tax minimizing strategy. Correctly using this strategy requires understanding how to avoid the consequences of the "kiddie tax" on a child's unearned income. This tax tip also explains a taxpayer's alternatives for reporting shifted income.

Two reasons to shift
Taxpayers benefit in two different ways when they shift income to family members in lower income tax brackets. Properly shifting income reduces both income tax liability and your adjusted gross income (AGI). How does this work?

Are you a taxpayer whose marginal tax rate is more than 15 percent? Shifting income to other members of the family saves income taxes for taxpayers above the 15 percent income tax bracket. For example, a parent in the 39.6 percent income tax bracket who shifts income to a child in the 15 percent income tax bracket saves 24 cents on every dollar of income shifted.

Properly shifting income not only decreases your income taxes but also lowers your Adjusted Gross Income (AGI). Numerous income tax provisions, especially the new ones enacted through the Taxpayer Relief Act of 1997, are phased out as your AGI increases. Lowering your AGI increases your eligibility for a number of these tax breaks.

Let child sell capital gain assets
So you've transferred some of your income into a savings account or mutual fund in your child's name. You can probably use this shifting strategy to reduce your income taxes even more. Have potential income tax consequences of a sale discouraged you from selling any of your assets? Consider transferring them to your child. Your child can then sell the asset and have the resulting gain taxed at a lower tax rate. The table and example below clarify this strategy.

For example, suppose you purchased stock many years ago for $500. The stock has appreciated in value to $10,000. Assume you are in the 28 percent income tax bracket. Selling the stock yourself results in a long-term capital gain of $9,500. You will pay income tax of $1,900 -- $9,500 gain x 20 percent long-term capital gains tax rate.

How are the taxes due affected if you give the stock to your child? Assume she is in the 15 percent income tax bracket. Her capital gain is still $9,500; however, the tax is now the $9,500 gain x 10 percent long-term capital gains tax rate, or $950.

Remember the gift tax rules when using this income-shifting strategy, especially the transfer and subsequent sale of highly appreciated assets. For the 2000 tax year you could have given up to $10,000 per year to a child without paying a gift tax. This tax-exempt amount increases to $20,000 for a married couple. These limits are adjusted annually for inflation. Consult IRS Publication 950 Introduction to Estate and Gift Taxes for additional information.

Beware of the "kiddie tax"
Income shifted to a child age 14 or older is taxed at the child's tax rate. However, income shifted to a child younger than age 14 is subject to the "kiddie tax" rules. The child's age at the end of the year determines if he is subject to these rules. The "kiddie tax" provisions limit the ability of children younger than age 14 to receive unearned income taxed at their lower tax rate. Unearned income includes income from interest, dividends, and capital gains. The rules are as follows:

• The first $700 in unearned income isn't subject to tax.
• The next $700 of unearned income is taxed at the child's rate, presumably 15 percent and lower than the parent's rate.
• Unearned income in excess of $1,400 is taxed at the parent's rate. This tax rate is the tax rate that would apply if this income were added to the parents' current taxable income.

Take special note of the last rule. The tax rate on unearned income isn't simply your current marginal income tax rate. This additional income could put you in a higher tax bracket. Also, if you have more than one child younger than age 14, you must combine all of the excess unearned income for all of these children, add this total to your taxable income, and allocate the resulting tax among the children based on each child's share of income.

There are two ways to pay this "kiddie tax." First, your child can file his own return and compute the tax on Form 8615, Tax for Children Under Age 14 Who Have Investment Income of More Than $1,400.

If you file your own income taxes with Form 1040 or Form 1040NR, you may prefer to report the income on your own return. You will need Form 8814, Parents' Election to Report Child's Interest and Dividends. Attach a separate Form 8814 for each child who owes this "kiddie tax." Be aware that you can make the election for one or more children and omit it for others. Also note that you can't file Form 1040A or Form 1040EZ.

The strategy for combating this tax is to restrain the child's unearned income less than $1,400 until he reaches age 14. You can invest your child's money in growth mutual funds that don't pay dividends. Also, Series EE Savings Bonds are attractive since you can postpone recognizing interest earned on these bonds until after the child reaches age 14. For additional tax information in this area, consult Part 2,. Tax on Investment Income of Child Under 14 of IRS Publication 929, Tax Rules for Children and Dependents.

Conclusion
Don't assume you can casually shift income to your children and avoid paying taxes. Properly shifting income will decrease both your tax liability and your adjusted gross income. For instance, shifting an appreciated asset increases the savings from this tax minimizing strategy. This tax tip also explains other details involved in this strategy. You can avoid the consequences of the "kiddie tax" on a child's unearned income. You also have a few alternatives for reporting shifted income.

--Jan. 18, 2001