Income Splitting Issues and Opportunities
If one can successfully direct the recognition of income away from higher toward lower-taxed family members, more after-tax wealth will remain in the overall family unit. Here’s why.
by Mark Altieri and Linda Zucca/The Tax Adviser
Parents and grandparents often find themselves with large amounts of appreciated capital wealth. The rates of taxation on long-term capital gains are generally 15 percent for higher income individuals and zero percent (starting in 2008) for lower income individuals. Ordinary income rates range from a low of 10 percent to a high of 35 percent. Children and grandchildren generally are subject to the lower ordinary rates, while parents and grandparents are generally subject to the higher rates of ordinary income taxation.
Basic Concepts of Income Splitting
If one can successfully direct the recognition of income away from higher toward lower taxed family members, more after-tax wealth will remain in the overall family unit.
Example: Daughter L, age 18, is in the 10 percent tax bracket on ordinary income and has no investment income. Her father, M, is in the 35 percent tax bracket and has $200,000 in a money market account earning five percent interest. M would like L to receive and pay tax on the income earned on the $200,000.
Focusing only on income taxation (gift taxation with regard to large gratuitous transfers also must be scrutinized by the tax adviser), if an income-splitting plan can be implemented, L would receive and be taxed on the income and the family’s income taxes would be decreased by $2,500.
Income From Personal Services
It is an established principle of federal income taxation that income generated from personal services will be included in the gross income of the person who performs those services. In Lucas v. Earl, Justice Holmes created the famous metaphor to explain that the fruit (income) must be attributed to and taxed to the tree (the earner of that income). An assignment of income does not shift the liability for the tax, even where the earned income was not yet contractually due and payable.
Income From Property: A More Flexible Rule
Unearned income, such as capital gains, dividends, interest, rentals and royalties, is derived from property ownership. Unlike personal service income where the fruit (income) cannot be separated from the tree (earner), the income can be split by transferring legal ownership of the underlying property. Subject to the kiddie tax rules (discussed below), if there is a bona fide transfer of ownership in the underlying property, the incidents of taxation can be transferred.
A transfer to a trust or pursuant to the Uniform Gifts to Minors Act can be disregarded as a sham under the substance-over-form rule if the custodian deals with the property in a way that is factually inconsistent with his or her custodial duties.
Where legal ownership of income producing property is transferred after income from the property has accrued but before the income is recognized to the donor, further analysis is required. The concern here is generally with accrued but unpaid interest income.
Major Impediments to Income Splitting the Kiddie Tax
Prior to 1987, a parent could readily shift unearned income to a child via a transfer of ownership of income-producing property. The child would pay no tax on income to the extent sheltered by the child’s exemption (which was allowable then) and thereafter at the child’s lower rate. Sec. 1(g) now generally taxes unearned income of children under age 18 at the parents’ highest rate of taxation. More specifically, the age restriction applies to a child who has not attained age 18 before the close of the tax year. In addition, either parent of such a child must be alive at the close of the tax year for the kiddie tax restrictions to be applicable.
The Small Business and Work Opportunity Tax Act of 200710 (SBWOTA) significantly expanded the kiddie tax rules going into the 2008 tax year. Amended Sec. 1(g) now not only affects a child who has not yet attained age 18, but many other children under age 24 as well. Under current law, a child who is 18 or is a full-time student aged 19 to 23 is subject to the kiddie tax rules if the child’s earned income does not exceed one-half of his or her support.
It is net unearned income that is taxed at the parents’ rate. The definition allows a setoff in 2008 of $900 plus the $900 standard deduction for a dependent taxpayer. Thus, in most cases there will be an $1,800 buffer (for 2008) before actual net unearned income generated is subject to the kiddie tax. This amount is adjusted for inflation each year. Thus, a significant amount of unearned income can still be split off to younger children each year as long as legal ownership has been properly conveyed to the child.
Nontaxable Uses of Effectively Split Income
There is one last major impediment to effective income splitting: What can the children (through their custodian or trustee) use the income for? Sec. 677 provides that trust income used to relieve the trust grantor of a support obligation causes the grantor to be taxed to the extent that the trust income does in fact relieve the taxpayer of his or her support obligation to the person benefitting from the actual distribution. Rev. Rul. 56-48416 and Rev. Rul. 59-35717 work an identical (actually broader) result under Sec. 61 to the extent that property transferred to minors under the Uniform Gifts to Minors Act is used for the benefit of the child in a way that discharges or satisfies a legal obligation of any taxpayer. Although the use of a trust as an income-splitting entity was dealt a blow by the 1993 Revenue Reconciliation Act’s severe compression of the 35 percent tax brackets for trusts, trusts can still be a viable tool in the income and estate planners’ repertoire.
This raises the question of what is a support obligation. The cited revenue rulings and regulations state that a support obligation is to be determined under relevant state law. One must then explore parental support obligations under general state law support statutes.
Caution: Many nontax divorce cases have considered a parent’s legal obligation of support. Although these cases certainly are relevant to the issue of support under state law, the tax issue examined here could be easily confused because parents have the ability to contractually modify the standard state law support obligation in a divorce and support agreement. Only a relatively few cases have focused directly on the income tax consequences of a parent’s legal obligation of support (the issue being examined here).
Because of the wide variation in the state law definitions of what constitutes parental support obligations, this analysis can range across a wide, often strained, definitional realm. For example, what if the dependents have sufficient resources of their own (previously provided by gift from the parents or grandparents) to provide for their own support? Regs. Sec. 1.662(a)-4 states that for the grantor trust rules, the legal obligation to support a child arises only if the state law obligation is not affected by the adequacy of the child’s own resources.
At the time of the Stone (T.C. Memo, 1987-454) decision, the California support statute provided that “the father and mother of a child have an equal responsibility to support and educate their child in the manner suitable to the child’s circumstances, taking into consideration the respective earnings or earning capacities of the parents.” The Stone court, however, specifically cited to the Brooke (468 F.2d 1155 (9th Cir. 1972), affg, 292 F. Supp. 571 (D. Mont. 1968) opinion when noting that the “holdings of other courts with respect to similar obligations under the laws of other states, are of only limited aid here [under California law].”
The court then went on to dismiss the taxpayers’ claim that they only had a legal obligation under California law to provide a public school education to their children. The critical factor was that the taxpayers had sent their children to private schools for two or three years prior to the creation of the funding trust. This allowed the court to “assume that the education that petitioners chose for their children was ‘imminently reasonable in the light of the background values and goals of the parent as well as the children.’ They were clearly both willing and able to finance the private high school education of their children.”
Time will tell if the significant tightening of the kiddie tax rules under SBWOTA will cause the taxing authorities to deemphasize the case law and focus only or primarily on revised Sec. 1(g). Without further guidance, applicable state law will need to be closely scrutinized. If there are no cases analyzing the federal income tax implications of a parent being relieved of a state law support obligation, look at the state case law refining the support obligation in a divorce context.
The less it looks as if the trust or custodial account was set up to fund specific preexisting obligations, the better it might look to the reviewing court, especially the Tax Court.
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Mark Altieri is an associate professor of accounting at Kent State University in Kent, OH and is special tax counsel to the law firm of Wickens, Herzer, Panza, Cook & Batista in Avon, OH. Linda Zucca is an associate professor of accounting at Kent State University. Altieri and Zucca are contributing writers of The Tax Adviser. Their views as expressed in this article do not necessarily reflect the views of the AICPA, The Tax Adviser or the CPA Insider™.
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