Published by Tyler Silverthorn, CFP®
As you may have heard, Congress recently passed The Tax Cuts and Jobs Act. You also have probably heard debates on who the tax changes benefit most: corporations, the top 1%, middle-income families, or low-income families. One group that is often left out of the discussion are children. Minors with unearned income which is subject to the Kiddie Tax may potentially receive the largest tax savings of all.
As a brief history lesson, Congress passed the Kiddie Tax law in the 1980’s as a measure to tax income that wealthy parents were shifting to their lower taxed children. The individuals affected by the Kiddie Tax applies have not changed. Children under 19 years old with unearned income and children 19 -23 years old that are full time students with earned income that does not exceed half of the annual expense to support the child are potentially subject to the Kiddie Tax. The previous Kiddie Tax law provided for a small standard deduction and the potential for the child’s income to be taxed at the parent’s marginal rate. Under the new Kiddie Tax, starting in 2018, a child receives the same $12,000 standard deduction as any other individual, with all income taxed at the estate and trust tax rates. No longer will the Kiddie Tax be impacted by the parent’s marginal tax rate. Additionally, parents with multiple children with unearned income used to have to combine all the income and calculate a single Kiddie Tax. That rule will also cease to apply under the new tax system.
|Standard Deduction||Earned Income plus $350 not to exceed $1,050, or $1,050||$12,000|
|Tax Rates||Up to $2,100 unearned income – 10%||Up to $2,550 10%|
|$2,550 to $9,150 24%|
|Unearned Income above $2,100 – Parents Marginal Rate||$9,150 to $12,500 35%|
|Over $12,500 37%|
In many ways, the changes simplify the Kiddie Tax while simultaneously providing for new planning opportunities for parents. Although some individuals and families saw their standard deduction double, the Kiddie Tax had its standard deduction increase by over 1,100%. The result is an additional $10,950 of income that is no longer subject to any tax. This will benefit children who have earned income (from a summer job), as well as unearned income (from investment income). Children with unearned income could potentially see the largest benefit. Where previously a child with $5,000 of income and parents at the top tax rate of 39.6% would have owed almost $1,000 in taxes, now there would be no tax liability. This tax savings increases as the income of the child increases. So, should parents now gift more assets to their children to take advantage of the Kiddie Tax changes?
First, regardless of the tax implications associated with the Kiddie Tax, it is important to remember that any assets given to your children are theirs and no longer yours. The assets you give should be ones that you do not need for yourself and you are comfortable with your child having access to once they turn 18. If the child has no earned income, the $12,000 standard deduction can be fully applied to offset unearned income. However; as the Kiddie Tax will now utilize the compressed estate and trust tax rate, if your child has a summer or part-time job then it is important to be mindful of the compressed tax rates.
Perhaps, you decide that gifting assets to your son or daughter makes financial sense. What assets do you gift to them? The three main options are investments (stocks & bonds), income producing property (rental property), or ownership in the family business.
- Gifting investments provides for the most flexibility, as they are liquid. Your cost basis is passed along to your son or daughter, so gifting them appreciated stock which you plan to sell could save you 20% on the capital gains tax. If you gift to the child annually, eventually gifting them appreciated stock becomes somewhat irrelevant as their portfolio will be large enough that the $12,000 annual standard deduction will be needed to offset the dividends and capital gains of their investment portfolio.
- Gifting income-producing property can be a nice strategy to fund private schooling and college. If you own rental properties that are generating positive cash flow and your income is above $250,000 for married filing jointly, you are paying 23.8% in tax 20% long-term and 3.8% net investment income). As a minor, your child is not able to make financial decisions for themselves, so as the parent, you will act as the custodian or guardian of the assets gifted to them. Thus, you may utilize the assets for non-parental obligations, such as summer school, a car, college, or private school. Having your child’s income-producing property cover the cost of private school could save you $2,856 in taxes for $12,000 of rental income.
- How about gifting ownership of your business to your children? This has many of the same benefits of gifting them income-producing properties with some potential additional benefits and some increased complexity. The new tax law reduces the corporate tax rate to 21%, while also allowing pass-through entities, such as Limited Liability Companies and S-Corporations (the structure of most family businesses), to deduct up to 20% of their earnings before paying tax. Gifting shares of your business to your children may reduce your estate tax liability by annually reducing your net worth with the gifts along with the growth of the business already being outside of your estate. With the estate tax exemption doubled for a married couple from ($11.2 million to $22.4 million), gifting shares of your business to reduce your future potential estate tax liability may now seem unappealing. However, the increase in the estate tax exemption is set to sunset in 2025. In other words, absent Congress passing a future tax bill, in 2026 the estate tax exemption will resort back to the 2011 base of $10 million per couple, indexed for inflation.
Before gifting shares of ownership to your children, it is important to note that a Limited Liability Company may have voting and non-voting shares. Both types of shares are treated the same for distributions, but as the name implies, the owner of non-voting shares has no voting rights to make company changes. Gifting of non-voting shares can potentially reduce current income tax liability, and future estate tax liability, without impacting control of the company.
As an owner of an LLC or S-Corp, you are entitled to take ownership distributions. The benefit of ownership distributions is that they are not subject to payroll taxes. Payroll taxes are comprised of a 6.2% social security tax on the first $128,700 of income, plus a 1.45% Medicare tax on all income. Both the employer and employee pay the tax. Meaning, as a business owner, this results in payroll or FICA tax of 15.3% on the first $128,700 of income and a 2.9% tax on income above $128,700. An owner who actively participates in the business must pay him or herself a reasonable salary. This is to avoid owners from claiming no salary and having all of their income come from an ownership distribution.
Let’s assume you own a business where you have a $350,000 salary, along with $500,000 of ownership distributions. Ignoring deductions, this results in $850,000 of taxable income with a federal tax liability of $253,879 or a blended rate of 29%. You also have a daughter who is starting 6th grade at your favorite private school, where tuition is $15,000. To take advantage of the changes in the Kiddie tax, you gift your daughter non-voting shares of your business valued at $80,000. For the next seven years, your daughter receives an ownership distribution of $12,000. Because she is an owner who is not actively participating in the business, her distribution is not subject to any payroll tax. As mentioned earlier, a parent may use the assets to cover non-parental obligations, such as private schooling. From 6th through 12th grade, you use the $12,000 of income to cover the majority of the cost for your daughter’s private schooling. As your daughter now has a $12,000 standard deduction, no federal, state, or payroll tax is owed. This results in an annual tax savings of 40.8% (37% top income rate plus 3.8% Medicare surtax on income over $250,000) or $4,896! At her graduation, the total tax savings will be $34,272. If you have multiple children, the potential tax savings could be even larger.
|Tax Rate||Maximum Tax Savings|
|Investments – Bonds or Stock||Short-term – Ordinary Income||23.80%|
|Rental Property||Long Term – 15% or 20%||23.80%|
|Shares of a Business||Ordinary Income||40.80%|
Before you rush out and gift shares of your business to your children, there are several issues to keep in mind. First, no tax change is permanent. Even the tax changes that are not set to expire until after 2025 could be changed by a future tax bill. Another question to ask is if your business is currently structured to allow for a gift of non-voting shares. Lastly, how do you feel about giving your children ownership of your business, even if it is nominal and non-voting shares?
It is important to incorporate any tax or gifting strategy into your overall financial plan. With the recent changes to the Kiddie Tax, now might be a good time to discuss planning opportunities with your tax professionals and financial advisors.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice.