Transferring Assets to Children
Tax benefits associated with transferring assets to children include:
• Shifting taxable income and gains on asset sales to the child’s lower rate.
• Removing the asset, along with any future appreciation, from the parents’ taxable estate.
However, a portion of the unearned income of children under age 18 and many who are age 18 (or age 19–23 and full-time students) may be taxed at the parents’ rate.
Notice: Assets held in a child’s name can reduce the family’s financial aid award under the federal formula for computing need-based aid. This could negate any tax savings resulting from asset transfers.
Using UGMA/UTMA Accounts:
Usually, assets transferred to minors are held in custodial accounts under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA).
• Income earned on UGMA/UTMA assets is taxable to the child.
• Generally, the child has full access to the funds when he or she reaches the age of majority (typically age 18 or 21, depending
on the particular state laws). For that reason, significant assets are usually transferred through a trust.
Notice: If a parent who transfers property to a child’s custodial account dies while he or she is the account custodian, the value of the custodial assets are included in the parent’s gross estate. This is not the case when one parent transfers separate property to an account of which the other parent is the custodian.
Using Trusts to Shift Income to Children
Many parents are hesitant to transfer large amounts to custodial accounts because they do not want their children to have unrestricted access to the property when they reach the age of majority. Instead, transfers in trust are commonly used to transfer the property (and shift related income) while allowing the parents to maintain some control over the property. There are several different ways to transfer assets in trust for a child. Each has different income and estate tax consequences. The choice depends on the parent’s objectives. Typically, Crummey trusts are used because (with the exception of the withdrawal right) the parent can maintain substantial control over the assets, which can remain in trust past the beneficiary’s 18th or 21st birthday.
When transferring assets to the taxpayer’s children, appreciated property should always be given to children before entering into a contract for its sale. If a contract to sell the property is entered into before it is transferred to the child, the parent will be taxed on the gain under the assignment of income doctrine.
Employing a Child
Another technique for shifting income to children is for parents to employ them in the family business. If the compensation is reasonable relative to the work performed, the child has earned income (not subject to kiddie tax) and the business deducts the expense. Wages paid to a child under age 18 from a parent’s sole proprietorship or partnership (if parents are the only partners) are exempt from FICA taxes [IRC §3121(b)(3)]. FUTA tax exemption applies to a child under age 21. [IRC §3306(c)(5)] In addition to the earned income being taxed at the child’s rate, a child may shelter all or a portion of it with the standard deduction.
Notice: Compensation paid to the child in the family business must be reasonable for the work performed. So, it is important to maintain records supporting the type of work performed and the amount of time worked.
Tip: Children age 18 (or age 19–23 and full-time students) can avoid the kiddie tax if their earned income is more than half of their support. Employing children in a business can increase their earned income and potentially get them out of the kiddie tax trap.