Income Shifting is the process by which taxpayers can decrease their tax liability as well as their adjusted gross income as a result of shifting income between family members. In order to benefit from income shifting, taxpayer must use care to avoid the consequences of the "kiddie tax" on the unearned income of a child dependent.
Income shifting can occur in situations where an appreciated asset is transferred from an individual in a higher tax bracket to a family member who is in a lower tax bracket. The result could have implications that would tax the asset at 15% as opposed to 35%.
Income shifting works by transferring property from one family member in a high tax bracket to a family member in a lower tax bracket, thus saving a substantial percentage on taxation of the asset. For example, if a parent has stock that has appreciated in value, the taxpayer would have to pay taxes on that asset at the tax percentage for their bracket – let’s say it’s 33%. By shifting ownership of that stock to their child, it would be taxed at the lowest bracket – a 10% capital gains tax.
There are caps on the amount of money or assets that can be “gifted” to individuals every year. In 2009, the IRS established the maximum allowable gift to a child may not exceed $13,000. This means that a parent can exclude that $13,000 from their AGI, but may not exclude any amount over that. If a parent has 6 children, they could theoretically make 6 gifts of $13,000 and exclude all of the gifts provision. The recipient (i.e. the children) would have to pay tax on the gifted amount, but generally, the tax is much lower for the children then it would be if taxed under the tax bracket of the parents.
The “Kiddie Tax” was enacted by Congress in order to close a loophole that may lawmakers believed existed in the gift tax provisions. The Kiddie tax is applicable to all unearned income and includes assets such as stock, mutual fund dividends, interest payments and cash gifts.
The Kiddie tax is activated through IRS Form 8615, which must be filed for children who receive investment income of an amount greater than $1800 in a tax year. The “Kiddie Tax” currently applies to children who are under the age of 18 and who have investment income over $1,800. When a parent “gifts” money or assets to their child, the first $850 is gifted tax-free. The next $150 is taxed at 15%, and any amount over $950 is taxed at the tax rate of the parents.