Managing Money : Shifting Assets to Kids Is Still Possible

Shifting assets or income to your kids, while giving yourself a tax break to boot, is much harder under tax reform. But there are still many ways to do it.

Tax reform created what has unaffectionately become known as the “kiddie tax.” Any income above $1,000 a year that your children under the age of 14 earn from assets (such as stocks, bonds, cash, real estate) received through gifts, trusts or inheritance is taxed at your presumably higher rate. Your kids get a break only on the first $500 of such “unearned” income, which is tax-free, and the second $500, which is taxed at their presumably lower rate.

Only after your children reach age 14 does unearned income become taxed at their rate. Before tax reform, all unearned income was taxed at your children’s rate, regardless of age.

The new rules reduce the tax advantages of several devices, including once popular Clifford Trusts, through which you could, in effect, loan income-producing assets to children for at least 10 years, then take the assets back.

But there are still several relatively simple, time-honored methods to give assets to your children--perhaps to help pay for their college education--that will produce income taxed at their lower rate. You can place certain assets, such as cash or marketable securities, into an account in a child’s name but managed by you, under the Uniform Gifts to Minors Act.

And giving these assets might help you lower your taxes. You may reduce capital gains taxes by giving assets that have risen in value. And tax laws still allow you to transfer up to $10,000 annually ($20,000 for both parents together) to each child, free of federal gift taxes. Doing so reduces the size of your estate, which in turn could reduce future estate taxes--which run as high as 55%--to be incurred by your children.

Among the more popular methods:

- Give tax-free municipal bonds or bond mutual funds. Perhaps the best type to give to your children are zero-coupon municipal bonds. They don’t pay interest directly but instead do so by growing in value over time. Such growth in value will be tax-free, and the bonds can be used to help pay for your kids’ tuition.

Zero-coupon bonds made from Treasury bonds or other taxable instruments are less attractive because accrued interest income is taxable each year. But if that income is your child’s first $500 each year, it still would be tax-free.

- Give Series EE savings bonds. These bonds, like zero-coupon bonds, pay interest indirectly by growing in value over time. But taxes on the gain can be deferred until the bonds mature, preferably after your children reach 14 so that income can be taxed at their lower rate.

Alternatively, you can elect to pay tax on each year’s gain annually instead of at maturity. That would be advantageous if the annual gain is your child’s first $500 in unearned income, which would be tax-free.

- Give appreciated assets. Unfortunately, many parents sell stocks that have gained in value and use the proceeds to pay for their childrens’ education. You would be much better off giving stock to your kids. If your child is 14 or over, he can sell the assets and the capital gain will be taxed at his lower rate.

- Give stocks or mutual funds of small, fast-growing companies. These typically don’t pay much dividend income, so they won’t result in much annual tax liability. But they have high potential to increase in value over time; such appreciation is not taxable until the stocks or funds are sold. So if your children sell them after they reach 14, the capital gains will be taxed at their lower rates.

- Give real estate. Vacant land, which can gain in value but produces little or no annual income that is taxable, may be most suitable. Having your child sell it and be taxed on the gain at his low rate instead of your higher rate will save capital gains taxes.

A major caution: Giving property to a minor generally requires that you appoint a trustee, other than yourself, to manage the property, says Stephen P. Kunkel, tax partner in the Los Angeles office of Pannell Kerr Forster, an accounting firm. That is because a minor doesn’t have legal capacity to conduct transactions.

But the need for a trustee could add considerable expense and complexity, making gifts of real estate impractical unless large values are involved, Kunkel argues.

- Give investment-oriented life insurance policies. Their cash value builds up tax-free, and if children cash them in after age 14, the buildup will be taxed at their lower rate. Also, children can borrow from the policies at low rates to pay college bills.

But be aware that new rules pending in Congress may curb tax breaks on investment-oriented life insurance. And some policies carry high set-up and termination fees. So consult with advisers before proceeding, Kunkel suggests.

- Employ your child in your business. The kiddie tax doesn’t apply to income that children earn from working. That income is taxed at their rate, and it is deductible to you as a business expense. But children must render documentable services and must earn a fair market wage.

With this year’s standard deduction rising to $3,000, your child’s first $3,000 in earned income will be tax-free, says Sidney Kess, tax partner in New York at the accounting firm of Peat Marwick Main. The next $2,000 can be tax-free if your child invests it in an individual retirement account. New rules under tax reform that restrict the deductibility of IRA contributions for adults with retirement plans at work don’t apply to children, Kess notes.

One caution: Many institutions don’t like to set up IRAs for minors, Kunkel says. But you should be satisfied if your young children earn up to the $3,000 standard deduction.

- Set up trusts. A charitable remainder trust, for example, could be advantageous if your children are already 14 or older. You can set up the trust to provide income for your children for a certain number of years, upon which the trust assets revert to your favorite charity. The advantage to you: A tax deduction now based on the present value of the assets that will go to the charity.

Bill Sing welcomes readers’ comments but regrets that he cannot respond individually to most letters. Write to Bill Sing, Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.