DOING IT FOR THE KIDS: INCOME SPLITTING TECHNIQUES THAT WORK AND THOSE THAT DON'T

by Mark P. Altieri

Overview. The following are some overview points compelling us to review the concept of so-called "income splitting". Parents and grandparents often find themselves with large amounts of appreciated capital wealth. The rates of taxation on long-term capital gains are generally 20% for higher income individuals and 10% for lower income individuals. Ordinary income rates range from a low of 10% to a high of about 39%. Children and grandchildren generally are in the lower rates, while parents and grandparents are generally subject to the higher rates of taxation.

Basic Concepts Of Income Splitting. If we can successfully direct the recognition of income away from higher toward lower taxed family members, more after-tax wealth remains in the overall family unit (rates referenced below will be rounded up for simplicity sake).

Example: Lauren (daughter — age 15) is in the 10% tax bracket on ordinary income and has no investment income. Mark (father) is in the 40% tax bracket and has $200,000 in a money market account earning 5% interest. Mark would like Lauren to receive and pay tax on the income earned on the $200,000.

If an income splitting plan can be implemented, Lauren would receive and be taxed on the income, and the family's taxes would be decreased by $3,000:

Decrease in Mark's tax —
(.05 x $200,000).40 = ($4,000)
Increase in Lauren's tax —
(.05 x $200,000).10 = 1,000
Decrease in the family's taxes ($3,000)

Income from Personal Services. It has long been a well-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 the 1930 U.S. Supreme Court case, Lucas v. Earl, Justice Holmes used a fruit and tree metaphor to explain that the fruit (income) must be attributed to and taxed to the tree (the earner of that income - Mr. Earl).

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) can't be separated from the tree (earner), we have the ability to split income by transferring legal ownership. Ownership of the fruit-producing tree can be legally changed. Subject to the Kiddy Tax rules (discussed below), if there is a bona fide transfer of ownership in the underlying property, we can transfer the incidence of taxation.

Example: Continuing our earlier example, Mark would like Lauren to receive and pay tax on the income earned on the $200,000. Mark can accomplish this at the cost of losing ownership of the $200,000. He can transfer ownership of the money market account to Lauren as a completed gift pursuant to the Uniform Gifts to Minors Act and retain custodial control over the money. Lauren would receive and be taxed on the income and the family's taxes would be decreased by $3,000 as illustrated earlier.

Note: Custodianship or a transfer to trust 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. We are generally concerned here with accrued but unpaid interest income.

Interest. Interest income is deemed by IRS Revenue Ruling and case law to accrue daily. Interest for the period that includes the date of a transfer is allocated between the transferor and transferee.

Example: Mark gave his son, Bryan, bonds with a face amount of $10,000 and an 8% annual interest rate. The gift was made on January 31, 2001, and the interest was paid and received by Bryan on December 31, 2001. Mark must recognize $68 in interest income (8% x $10,000 x 31/365). Bryan will recognize $732 in interest income ($800 - $68).

Dividends. Dividends paid on stock do not accrue on a daily basis. The determination to pay a formal dividend is at the discretion of the corporation's Board of Directors. The Board declares that a dividend will be paid to shareholders of record at a stated record date. Treasury Regulations state that the record date is the cut-off for determining the shareholders who are entitled to receive the dividend when stock is sold. If a shareholder sells stock after a dividend has been declared but before the record date, the dividend is taxed to the new owner.

If a donor gifts stock after the declaration date but before the record date, there is a split in case authority as to whom bears the taxable event of the ultimate dividend. The Tax Court has held that the donor/transferor does not shift the dividend income to the donee. The basic logic of the Court's holding was that the fruit had sufficiently ripened as of the declaration date to tax the dividend income to the donor

Example: On June 20, the Board of Directors of Bigsky Corporation declares a $1 per share dividend. The dividend is payable on June 30, to shareholders of record on June 25. As of June 20, Mark owned 200 shares of Bigsky Corporation's stock. On June 21, Mark sold 100 of the shares to Martin for their fair market value and gave 100 of the shares to his son Bryan. Assume both Martin and Bryan are shareholders of record as of June 25. Martin (the purchaser) will be taxed on $100. However, Mark (the donor) will be taxed on the $100 received by Bryan (the donee) because the gift was made after the declaration date of the dividend.

Major Impediment To Income-Splitting: The Kiddy Tax Rules. The Internal Revenue Code generally taxes unearned income of children under the age of 14 at the parents' rate of taxation. More specifically, the age restriction applies to a child who has not attained age 14 before the close of the taxable year. Additionally, either parent of such a child must be alive at the close of the taxable year for the Kiddy Tax restrictions to be applicable.

It is "net unearned income" of an under-14 child that is taxed at the parents’ rate. The definition allows a set-off in 2001 of $750 plus the $750 standard deduction for a dependent taxpayer. Thus, there will be a $1,500 buffer before actual net unearned income is generated and the Kiddy Tax becomes applicable. The formula is adjusted for inflation each year. Thus, a somewhat 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 per the earlier analysis.

Example: Chloe (daughter — age 4) is subject to tax at a 10% rate on long-term capital gains and has no investment income. Mark (father) is subject to tax at a 20% rate on long-term capital gains. Mark makes a completed gift to Chloe of zero basis stock. Deborah (mother), as custodian for Chloe, sells the stock after the gift triggering a $1,500 long term capital gain.

Decrease in Mark's tax —
($1,500 x .20) = ($300)
Increase in Chloe's tax —
($1,500 - $750
standard deduction) x .10 = $ 75
Decrease in the family's taxes ($225)

In summarizing what we have learned so far, earned income cannot be split-off from the earner of that income. Unearned income, however, can be manipulated, as the income will follow the legal owner of the property. Even after effective transfer of legal ownership, however, the unearned income now being taxed to the child/owner needs to run the Kiddy Tax gauntlet. As we know, there is the $1,500 exception to the Kiddy Tax for a child under the age of 14. More significantly, with regard to a child over the age of 13, we can split income to our hearts content by transferring ownership of the property.

Non-Taxable Uses Of Effectively Split Income. We still have to contend with another major impediment to effective income splitting. What can the children (through their custodian or trustee) use the income for? The Code and IRS Revenue Rulings provide that custodial account and trust income used to relieve a parent of a support obligation causes that parent to be taxed to that extent. Note that the use of a trust as an income-splitting entity was dealt a severe blow by the 1993 Revenue Reconciliation Act's severe compression of the 39% tax bracket for trusts ($8,900 for tax year 2001). Therefore, gifts to minors under the Uniform Gifts to Minors Act will now be the norm.

This then raises the question of what is a "support obligation." The parental support obligation generally extends to so-called necessaries, which include suitable shelter, food, clothing and basic education. Whether support extends to other items such as college expenses, private school tuition, vacations, cars, etc. is a trickier subject. The relevant authority states that a support obligation is to be determined under state law. We must then explore what are parental support obligations under state law, both under the general support statute as well as case law interpreting what state law support is vis-a-vis child support obligations in divorce decrees.

Let's lay the groundwork for this analysis under Ohio law by first looking at the law in other states. Because of the wide variation in a state law definition of what constitutes parental support obligations, this analysis can range across a wide, often strained, definitional realm. For example, in New Jersey, a grantor was taxed on trust income used to pay expenses of his children in attending private high school and college since such educational responsibilities were found to be within his legal obligation of support. The children's own resources did not affect the parents' support obligation. The New Jersey Court stated that although parents generally are not "under a duty to support children after the age of majority, in appropriate circumstances, parental responsibility includes the duty to assure children of a college and even a post-graduate education such as law school." The New Jersey law strongly insinuated that if there was an expectancy of a college education on both the parent and child's part, as well as an ability to pay on the parents' part, a college education would constitute a support obligation of the parent even where the child had reached the age of majority.

However, most states provide a less extreme interpretation of what is a support obligation of the parent relative to things such as private high school tuition, college tuition, and other luxury items such as child-owned automobiles.

In a Montana decision, a physician (Dr. Brooke), transferred real estate with a building that included a pharmacy, a rental apartment and the offices of his medical practice to his minor children. At a later point in time, Dr. Brooke was appointed guardian for his children's property. Dr. Brooke made rental payments to himself as guardian for the use of his medical office. Dr. Brook, as guardian, then used income to provide the children with insurance, music, swimming and speaking lessons, private school tuition, an automobile, and travel expenses. At the trial level, the District Court recognized that the amounts so expended were not legally required for the support and maintenance of the children. This non-support characterization was made despite the fact that Montana law required a parent to provide his or her children with "support and education suitable to his circumstances".

In a South Carolina decision, the grantor-father was not taxable on a trust fund used for his minor children's private school tuition and music and dancing lessons. The Court determined that the father had "no legal obligation under South Carolina law to send his children to private day school or to afford them music and dancing lessons." Another important elaboration in this case was that the father was careful not to personally assume any express or implied contractual obligations to make such payments. The schools in question entered into no contracts directly with the parents concerning attendance. Tuition was payable in advance of attendance, and the trust would make the check payable to one of the children, which was then endorsed for delivery to the school. The school representative receiving the advance payment was advised that they were being made from trust funds and not from the parents' own income.

In Ohio, the case law seems to take a largely Montana-type view of this issue. There are no tax cases interpreting Ohio support obligations. However, Ohio Revised Code 3103.03 limits the support obligation to minor children (under the age of 18 in Ohio), but will extend support beyond minority until the completion of full-time attendance at an accredited high school. O.R.C. 3103.03(B). Thus, college expenses for a child over the age of 17 would not be support in Ohio. With regard to private school expenses, absent a requirement to do so in a court ordered decree, where public schools are available, tuition payments for a child's attendance at a private school are not necessary for support. Mihna v. Mihna 549 N.E. 2nd 558 (1989).

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