Once upon a time, parents could build tax shelters by setting up Clifford trusts or other investment vehicles in their young child's name.
Then along came the "kiddie tax" provision of the 1986 Tax Reform Act, which boosted tax liability on the unearned income from these sources by as much as 20 percent.
"Congress felt that the traditional, gift-giving options taken by families were a form of withholding possible tax revenues," said Vern Martens, senior tax attorney with Merrill Lynch in Plainsboro, N.J.
"If they're earning money up in the mountains as a busboy, that's one thing," said Theodore Dickson, tax partner with New York law firm of Bower & Gardner. For Congress, taking away potential tax revenue is another.
Simply, unearned income is taxed as if it were received by the parents.
Under the 1986 tax law, children younger than 14 are taxed at their parents' marginal tax rate for unearned income in excess of $1,000, plus any allowable deductions over $500 -- unless the child's rate is higher.
When couples file jointly, the joint rate is used. The custodial parent's rate is used in the case of unmarried parents. And when spouses file individually or are divorced with joint custody of the child, the rate of the parent with the greater taxable income is applied. The maximum marginal rate, as high as 70 percent in recent years, is 38.5 percent for 1987.
The popular Clifford Trust, which held income-producing assets, such as stocks and bonds, for at least 10 years for its beneficiary, is no longer a viable option because parents would be liable for interest reported annually, Dickson said. He favors vehicles that allow income to be deferred until after children reach age 14.
One choice is the "old war bond," or Series EE. As a bond's value appreciates, no tax is paid. Income is only taxable when it's cashed in, he said. Long-term growth stocks are another possibility.
David Lajoie, a tax partner in Cooper & Lybrand's Dallas office, agrees that how one reports interest is the key way to get around the "kiddie tax."
Lajoie said the "Age 21 Trust," Section 2503(c) of the Internal Revenue Code, could also help parents. "It's an absolutely perfect type of vehicle for college education savings for the middle class," he said. Added to the code in 1954, this trust, unlike others, qualifies for an annual exclusion for gift taxes, Lajoie said. Each parent can deduct as much as $10,000 tax free on an annual basis.