Income splitting: issues and opportunities.

• Author: Altieri, Mark P.
• Position: Cover story

EXECUTIVE SUMMARY

* Because parents generally have a higher effective tax rate than their children, the parents have an incentive when possible to shift income to a child in order to lower the overall tax burden of the family as a whole.

* Tax law generally prohibits a parent from shifting income from personal services to a child; however, a parent can in some cases effectively shift income to a child by transferring income-producing property to the child.

The kiddie tax in many cases will prevent a family from gaining a tax benefit from transferring assets from the parents to a child by applying the parents' top tax rate to part of the child's income.

* The imputed interest provisions of Sec. 7872 work to prevent a taxpayer from transferring funds to a child through below-market rate loans by imputing interest income to the parent.

* The use of a custodial account or trust to avoid tax on income from property that is used to pay a child's expenses may be thwarted by a parent's legal obligations to support the child.

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Parents and grandparents often find themselves with large amounts of appreciated capital wealth. The rates of taxation on long-term capital gains are generally 15% for higher income individuals and 0% (starting in 2008) for lower income individuals. Ordinary income rates range from a low of 10% to a high of 35%. Children and grandchildren generally are subject to the lower ordinary rates, while parents and grandparents are generally subject to the higher rates of ordinary income taxation.

Basic Concepts of Income Splitting

If one can successfully direct the recognition of income away from higher toward lower taxed family members, more after-tax wealth will remain in the overall family unit.

Example 1: Daughter L, age 18, is in the 10% tax bracket on ordinary income and has no investment income. Her father, M, is in the 35% tax bracket and has $200,000 in a money market account earning 5% interest. M would like L to receive and pay tax on the income earned on the $200,000.

Focusing only on income taxation (gift taxation with regard to large gratuitous transfers also must be scrutinized by the tax adviser), if an income-splitting plan can be implemented, L would receive and be taxed on the income, and the family's income taxes would be decreased by $2,500 (see Exhibit 1).

Exhibit 1: Tax results of Example 1 Decrease in M's tax: (.05 x $200,000) x .35 = ($3,500) Increase in L's tax: (.05x$200,000)x.10 = 1,000 Decrease in the family's taxes: ($2,500) Income from Personal Services

It is an established principle of federal income taxation that income generated from personal services will be included in the gross income of the person who performs those services. (1) In Lucas v. Earl, Justice Holmes created the famous metaphor to explain that the fruit (income) must be attributed to and taxed to the tree (the earner of that income). An assignment of income does not shift the liability for the tax, even where the earned income was not yet contractually due and payable. (2)

Income from Property: A More Flexible Rule

Unearned income, such as capital gains, dividends, interest, rentals, and royalties, is derived from property ownership. Unlike personal service income where the fruit (income) cannot be separated from the tree (earner), the income can be split by transferring legal ownership of the underlying property. Subject to the kiddie tax rules (discussed below), if there is a bona fide transfer of ownership in the underlying property, the incidents of taxation can be transferred.

Example 2: Continuing Example 1, M would like L to receive and pay tax on the income earned on the $200,000. M can accomplish this at the cost of losing ownership of the $200,000. He can transfer ownership of the money market account to L as a completed gift. L would receive and be taxed on the income and the family's taxes would be decreased by $2,500, as illustrated in Exhibit 1.

A transfer to a trust or pursuant to the Uniform Gifts to Minors Act can be disregarded as a sham under the substance-over-form rule if the custodian deals with the property in a way that is factually inconsistent with his or her custodial duties. (3)

Where legal ownership of income-producing property is transferred after income from the property has accrued but before the income is recognized to the donor, further analysis is required. The concern here is generally with accrued but unpaid interest income.

Interest

Interest income is deemed by IRS revenue ruling and case law (4) to accrue daily. Interest for the period that includes the date of a transfer is allocated between the transferor and the transferee. The transferor must recognize the accrued income at the time it would have been recognized had the transferor continued to own the property.

Example 3: T, a cash basis taxpayer, gave his son, B, bonds with a face value of $10,000 and an 8% stated annual interest rate. The gift was made on January 31, 2007, and B was paid and received the annual interest of $800 on December 31, 2007. T must recognize $68 in interest income (8% x $10,000 x (31 / 365)) for the 31 days before the gift. B will recognize $732 in interest income ($800 - $68).

If B did not actually or constructively receive the interest that was payable as of December 31 until January 3, 2008, T, as a cash method taxpayer, would not recognize interest income until the interest was received by B in 2008. T would include the $68 accrued income in his gross income in the 2008 tax year.

Dividends

Dividends paid on stock do not accrue on a daily basis. The determination to pay a formal dividend is at the discretion of the corporation's board of directors. The board declares that a dividend will be paid to shareholders of record at a stated record date. Regulations (5) state that the record date is the cutoff for determining the shareholders who are entitled to receive the dividend when stock is sold. If a shareholder sells stock after a dividend has been declared but before the record date, the dividend is taxed to the new owner. (6)

If a donor gifts stock after the declaration date but before the record date, there is a split in case authority as to who bears...