Shifting income is a time-honored tactic of the wealthy to save taxes. Income is “shifted” or moved to a family member in a lower tax bracket.
Historically, shifting was done by moving money-making assets to a company or trust “owned” by the kids. Years ago Congress decided that the kiddies shouldn’t be letting daddy get out of paying lots of taxes by simply shifting the income. Congress started to place limits on how much passive income a kiddie could receive before the “Kiddie Tax” kicked in and the child had to pay income tax on his or her passive income at daddy’s rate.
While the kiddie tax clipped the wings of shifting income, it is still a useful tool that can be used in different ways.
Shifting income was traditionally achieved by moving a money-making asset to the children’s ownership so that any income from the asset would count as belonging to them, not Mom and Dad. Because children usually do not earn as much as their parents, they tend to be in a lower tax bracket. By shifting this income, a family could save ten or fifteen percent in taxes on the money earned by the children’s assets.
Professionals could shift income by holding their business equipment in a separate company that they have set up. Their main business could rent the equipment from the company that owns the equipment. The company that holds the equipment would be “owned” by the children or older members in the family. This is not only a good asset protection move, it can also save the family on taxes. The business gets a tax deduction and the kids or older family members get the rental money. More money ends up in the family’s pocket, because the family members who get the rental income are usually in a lower tax bracket than the professional and thus less money is paid in taxes by the family as a whole.
When income is shifted in this way, the parents can end up with a lower adjusted gross income (AGI). Having a lower AGI in is critical because an individual’s adjusted gross income affects what deductions can be taken and is the key element in determining his tax bracket.
Some time ago, Congress passed the “Kiddie Tax” to make shifting income less effective. The Kiddie Tax applies to passive or “unearned income.” It does not apply to earned income. Unearned income is income produced by assets, like rent or stocks. Earned income is the income an individual earns through selling goods or services.
The Kiddie Tax says that for kids up to 18 years of age, unearned income can be taxed at Daddy’s rate. The age is extended to 24 if the child is a student who is claimed as a dependent by Mom and Dad on their tax return.
Let’s say your child bought some stocks, bonds, real estate, or some other income producing assets on their own, with money they have earned. The income earned by the child’s assets will be subject to the Kiddie Tax. The child will pay tax at Dad’s rate, even if Dad had nothing to do with obtaining the asset. Fortunately every “child” gets an unearned income tax credit of around $2,000 each year. As a result, the first $2,000 in unearned income won’t be subject to the Kiddie Tax. Until the $2,000 limit is reached by each child, the Kiddie Tax doesn’t kick in.
There are a few other ways to get money to your family without messing with the Kiddie Tax. One is to hire your kids to work for you, which gives them earned income that is not subject to the Kiddie Tax. Another alternative is to shift income to other family members who do not fall in the age bracket covered by the Kiddie Tax. Older family members who need help are usually in lower tax bracket than the family members actually earning the money. If you shift the income to these older family members, the family as a whole saves taxes and more money is available to take care of aging parents, for example.