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June 24, 2007 -My wife and I heard that the reach of the kiddie tax was expanded by a new law change. Is this true?

As you probably know, after a bitter battle with Congress, an Iraq funding bill was recently signed into law. This legislation also included various changes to the tax laws including significant changes that can affect families with children under age 24. These changes involve the so-called kiddie tax and as a practical matter will first apply on 2008 tax returns. While the changes do not go into effect until next year, now is the time to undertake planning to reduce or eliminate the potentially higher family income taxes that could result from them.

For 2007, a child under age 18 pays tax at his or her parent's highest marginal rate on the child's unearned (investment) income in excess of $1,700. Unearned income within reach of the kiddie tax includes interest, dividends and capital gains.

The new law did not change the kiddie tax rules for children under age 18. But it did expand the kiddie tax to apply (starting next year) where:

. . .a child turns age 18, or turns age 19-23 if a full-time student, before the close of the tax year;

. . . the child's earned income for the tax year doesn't exceed one-half of his or her support;

... the child has more than $1,700 of unearned in­come (but the $1,700 may be higher

after an inflation adjustment is released later this year for 2008);

... the child has at least one living parent at the close of the tax year; and

... the child doesn't file a joint return for the tax year.

This expansion of the kiddie tax attempts to curtail the ability of parents to signif­ icantly lower their family's tax bill by transferring in­ vestment assets to low-taxed minor children to take advantage of a beneficial feature of the long-term capital gains rate.

This year, the top tax rate on most long-term capital gains and corporate dividends is 15%. But to the extent these items would otherwise be taxed in the two lowest tax brackets—i.e., the 10% and 15% brackets—they are taxed at 5% for 2007, and 0% for 2008 through 2010. Some families sought to benefit from these rates by gifting appreciated stock, mu­ tual-fund shares, and other securities to their low-income, young-adult children who (if no longer subject to the kiddie tax rules and if in one of the two lowest tax brackets) could then sell them tax-free in 2008, 2009, and/or 2010. The new law changes will eliminate the opportunity to do this. How­ever, if the earned income of a child over age 18, or age 19-23 if a full-time student, exceeds one-half his or her support, the kiddie tax rules won't apply and he or she will be able to take advantage of the 0% capital gains rates and his or her own bracket on other types of unearned income.

A child who was planning to sell stock next year to take advantage of the 0% capital gains rate but who would be snared by the expanded kiddie tax may be able to sell this year to gain the advantage of the 5% rate. This won't work if the child is subject to the kiddie tax this year.

Because of these impending changes, a parent may want to reconsider any planned transfers of in­come-generating stocks, bonds, and other invest­ ments to children age 18, or those age 19-23 who are full-time students. However, placing or moving a child's funds into investments that produce little or no current taxable income, can help avoid the kiddie tax. These investments include, for example, stocks and mutual funds oriented toward capital growth that pro­ duce little or no current income; vacant land expected to appreciate in value; tax-exempt municipal bonds and bond funds; and U.S. series EE savings bonds for which interest re­ porting may be deferred, qualified tuition programs (‘ ‘529 plans ’’); and Coverdell education savings accounts (‘ ‘CESAs ’’)

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