Phillip G. Sinclair

Certified Public Accountant
310 North First
Longview, Texas 75601
903-753-5871
Fax 903-753-5982



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SHIFTING INCOME TO DEPENDENT CHILDREN

Shifting income to your dependent children can reduce your tax burden. However, special tax rules apply to children under age 14 who have unearned income of more than a certain inflation-adjusted amount ($1,400 in 1999). Unearned income generally includes all income except wages, salaries, and self-employed earnings. This "kiddie tax" counteracts a variety of family income-splitting techniques that took advantage of the lower tax rates of the taxpayers' children by, in effect, taxing the family unit as a whole. Effectively, the tax imposes the parents' marginal tax rate on an under-age-14 child's 1999 unearned income in excess of $1,400, unless the child's tax rate is higher than the parents' tax rate.

For 1999, a dependent child (who is not blind) must file a return if (1) the child has unearned income in excess of $250, and also has some earned income, where the total of both exceeds $700, (2) the child has no unearned income and total earned income exceeds $4,300, or (3) the child has no earned income and unearned income exceeds $700.

The "kiddie tax" applies to any child who as of the close of the tax year (1) is not age 14, (2) has at least one living parent, and (3) has unearned income in excess of the inflation-adjusted amount ($1,400 in 2000). If these conditions are met, the child is subject to the kiddie tax regardless of whether he is a dependent.

An individual eligible to be claimed as a dependent on another taxpayer's return may not claim a personal exemption for himself. Thus, a child cannot claim a personal exemption ($2,800 in 2000) if his parents can claim an exemption for him; whether they actually claim the exemption is irrelevant.

The 2000 standard deduction for a child claimed (or eligible to be claimed) as a dependent on another return is the greater of (1) $700 or (2) the sum of $250 and earned income (not to exceed the $4,400 standard deduction that would otherwise be allowable). A child with no earned income may use a standard deduction to avoid tax on the first $700 of unearned income; the next $700 is taxed at the child's 15% rate. Therefore, in 2000, the kiddie tax provisions do not affect the child until unearned income exceeds $1,400 (or greater if the child itemizes deductions and deductible expenses directly connected to the unearned income exceed $700). As an alternative tax planning consideration, try contributing to a deductible or Roth IRA in the child's name. A $1,000 deductible IRA contribution would fully shelter the remaining taxable unearned income and eliminate the tax liability, however a contribution to a Roth IRA may be a better financial and retirement planning option.

If you have two or more children in the family under age 14 and each has more than $1,400 of unearned income, the tax for all of the children is computed by reference to their parents' income level and marginal tax bracket. Each child's tax result depends on the taxable income of the other children as well as the parents' taxable income.

If certain requirements are met the parents of a child under the age of 14 may elect to report his income on their return instead of filing a separate return for the child. When reporting a child's income on the parents' return, the first $700 (for 2000) is not taxed while the next $700 (for 2000) is taxed at 15%. (These amounts are adjusted annually for inflation.) The 15% tax on the child's income that is more than $700 but less than $1,400 is computed separately, then added to the parents' tax return. If the child's income exceeds $1,400, the excess is included as income of the parents' tax return and taxed at the parents' marginal tax rate.

When an election is made to report a child's income on a parent's return, the amount of the child's income, which would be taxed at the child's rate if a separate return were filed (i.e., up to $700), is automatically taxed at 15%. Thus, when a child's income includes capital gain distributions, there may be a slight increase (up to $35 per child) in the family's overall tax due solely to a higher rate (15%) being applied to the amount that would be taxed at a 10% capital gain rate if the child filed separately. A child's capital gain distributions may prove to be advantageous if a parent has capital losses that can offset the capital gains.

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Last Updated 01/03/2001