Five Ways to Reduce the Kiddie Tax

Beware of the ?kiddie tax.? This special tax code provision will affect more families on their 2006 tax returns due to a new tax law change. However, with proper planning, you may be able to reduce the impact of the kiddie tax for 2007 and future years.

Basic rules: Normally, income is taxed at the tax rate of the person who receives it. Under the kiddie tax provision, however, annual unearned income above a threshold ($1,700 for both 2006 and 2007) that is received by a child under age 18 is taxed at the top tax rate of the child?s parents. In other words, the tax on the excess income can be as high as 35%.

Prior to 2006, the kiddie tax only applied to children under age 14. The Tax Increase Prevention and Reconciliation Act passed last year raised the limit by four years. So the kiddie tax now applies to an older group of teenagers as well.

Even so, the kiddie tax may be reduced, or even avoided completely, with advance planning. Here are five possible strategies to consider:

1. Stay below the annual threshold. For instance, you can have your child invest in U.S. Savings Bonds. If your child waits until he or she is age 18 to redeem the bonds, none of the interest is subject to the kiddie tax. Similarly, investments in growth stock or growth stock mutual funds are not designed to produce current
income. So, if your child sells the shares to help pay for college or to buy a car, there?s no kiddie tax to pay (assuming the child is age 18 or older).

2. Consider investments that yield tax-free income. For example, if you shift some of the child?s money into municipal bonds, the income is generally exempt from federal income tax?no matter when it is received.

3. If you are the owner of a business (or are in a position of authority in a company), you can hire your child to work for you. Since the wages are earned income, the kiddie tax does not apply. Assuming the child is paid a reasonable amount for services actually performed, the business can deduct his or her salary.

4. Another possibility is to give some of your business stock to a child now and have the corporation redeem it when the child is older. This is a sophisticated technique that requires expert assistance.

5. Finally, if you own property that is not yielding much current income but is likely to appreciate in value over time, you may want to give the property to your child.

Reminder: Although the benefits of family income-splitting have been reduced in recent years, there?s still plenty of tax incentive to shift income to a young child. The differential between the top 35% bracket and the lowest tax bracket of 10% is a hefty 25%.

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