Minimizing AGI-based deduction limits by shifting family income: big savings possible despite the kiddie tax.

• Author: Gervais, Paul L., Jr.

After the enactment of the Tax Reform Act of 1986 (TRA), many taxpayers abandoned income-shifting strategies involving their young children. TRA Section 101(a)'s enactment of the "kiddie tax," combined with lower marginal tax rates, negated the remarkable tax savings possible before the TRA. However, recent tax law changes have restored some benefits of income shifting; most notably, Congress's penchant for deduction limits based on adjusted gross income (AGI) floors and phaseouts requires a closer look at family income-shifting techniques. This article examines the kiddie tax effect on AGI-based phaseouts and floors and illustrates how family income shifting to children under age 14 may still achieve significant tax savings.

The Kiddie Tax

Under Sec. 1(g), unearned income (e.g., investment income) of certain minor children is taxed at the parents' rate, while the child's earned income is taxed at the child's rate. Specifically, a child under age 14 at the end of 1995, with at least one living parent, is subject to kiddie tax if he recognizes unearned income over $1,300.(1) The tax imposed is the greater of - the tax on all of the child's income at the child's rate, or - the sum of the tax imposed at the child's rate on the child's taxable income as reduced by his "net unearned income," plus the child's share of the "allocable parental tax."(2)

* Net unearned income and allocable parental tax Sec. 1(g)(4)(A) provides that net unearned income is the excess of the portion of the child's AGI for the year that is not earned income over the sum of (1) the standard deduction available to certain dependents under Sec. 63(c)(5)(A) (for 1995, $650), plus (2) the greater of (a) $650 or (b) the child's allowable itemized deductions directly connected to unearned income.

Sec. 1(g)(3)(A) provides generally that allocable parental tax is the excess of the tax that would be imposed if the parents' taxable income included the child's net unearned income, over the parents' actual tax liability. Temp. Regs. Sec. 1.1(i)-1T, Q&A-14 states that parents with more than one child subject to the kiddie tax must increase their income by the unearned income of all their children subject to the tax. Each child is apportioned a share of the allocable parental tax based on the ratio of the child's unearned income to the total unearned income.

Example 1: H and W file jointly in 1995, reporting $70,000 of taxable income. Their two children, B and S, are under age 14 and have net unearned income of $3,000 and $1,000, respectively. For 1995...