Until recently, tax law subjected young children to the same tax rates as parents in an effort to steer parents away from avoiding taxes by stashing income-producing assets in their children's names. Known as the "Kiddie Tax," this provision applied to children from birth to age 14. From 14 on, however, teens' assets were taxed at their own rate--which was typically significantly lower than that of their higher-earning parents.
But now that the recently passed Tax Increase Prevention and Reconciliation Act has boosted the Kiddie Tax age limit to 18, older children face higher tax rates on income from interest, dividends and capital gains. "This will have some teenagers gagging on a silver spoon," says Bob D. Scharin, RIA senior tax analyst at New York City-based Thomson Tax & Accounting, a provider of tax information and software. "In many cases, parents and grandparents provide gifts of up to $12,000 to children each year as a way of shifting income and lowering their tax bite. Now, shifting income only works if the child is over 17."
From 2006 on, the Kiddie Tax applies to children under 18 who have more than $1,700 of unearned income, have at least one living parent at the close of the tax year and will not file a joint return for the designated tax year.
What's a parent to do? Low-income-producing, high-growth stocks or bonds can help minimize the tax implications, says Scharin, who notes that those with family businesses can also opt to employ a child. "The child's earnings won't be subject to the Kiddie Tax," he says, "and will generate a deduction for the family business, assuming the wages are reasonable for the work performed."
Jennifer Pellet is a freelance writer specializing in business and finance.