A very common and effective strategy of accumulating funds for future college costs is the use of income shifting. Income shifting from parents or grandparents to children or grandchildren is accomplished by putting income-producing assets in the children’s or grandchildren’s name. The related income generated by these assets is taxed at the child’s lower income tax rates, and thus, the family receives a tax benefit. This “tax scholarship” will help increase the amount of funds available for college. In addition to the income tax savings, there may also be considerable estate tax savings earned by shifting the asset to a child or grandchild. Several income shifting techniques will be discussed in this section.
Note: Because the 2003 tax bill decreased the ordinary income tax rates from 15% down to 10% for the first $9,325 of taxable income for single taxpayers (for 2017), income shifting has become an even greater tax saving strategy.
Standard Methods of Income Shifting
Parents can shift assets (and the resulting income) in one of four ways:
- Parents own appreciated and marketable assets which are capable of transfer to the child by gift, followed by a sale by or on behalf of the child.
- Parents with proprietorships or other businesses can pay compensation to the child during teen years.
- For parents with no appreciated assets or family compensation opportunities, they can shift after-tax dollars to the child as early as possible by annual gifts, so that growth and earnings on the investments are taxed at the child’s rates rather than parental rates.
- Parents can gift interests to the child using custodial accounts..
Shifting by Gifting Appreciated Assets
Gifts of appreciated assets to the child from the parents may be an effective method of shifting income to the child. If the gift is not made until the child needs the money for college, the parent can keep control of the asset until it is needed for college.
A gift of appreciated stock or raised agricultural commodities to children may be an effective method of shifting income to children to help pay for college costs. Normally, on the gift of an asset, the holding period carries over from the donor to the donee. However, with gifts of raised inventory given from a farm proprietor, the character of the asset changes from inventory to investment or capital asset status in the hands of the donee child. Accordingly, the most conservative approach to assure qualification for long-term capital gain status is to have the child hold the grain at least 12 months before sale.
Note: If a child is a minor, under state law, the parent generally must keep the net assets after the sale separate for the child or use the proceeds in a fiduciary capacity only for the child’ benefit. Therefore, the use of the net assets is very important. If the assets are used to buy the family car, the gain would be taxed back to the parents.
Note: Income-in-Respect-of-Decedent (IRD) assets (qualified retirement plans, IRAs, installment sale receivables such as land sale contract receivable, U.S. Savings Bonds, annuities, etc.) cannot be transferred by gift without first triggering income recognition to the parent.
Shifting Income by Compensating the Child
Parents with proprietorships or other businesses that can pay compensation to the child will achieve tax benefits that can be used to pay for part of the college cost.
Note: A child can also be employed to:
- help move (moving expense),
- help keep track of investments (investment expense),
- help with home office work (job-related expense), or
- perform household duties (non-deductible expense).
The compensation paid to the child is earned income and is not subject to kiddie tax.
Sole proprietors, or husband-wife partnerships, can pay their children under age 18 for services in the business without Social Security or self-employment tax]; this makes salaries efficient whenever the parent income tax bracket is greater than the child’s bracket.
Note: If a child is under 21 years of age and employed by parents to perform household duties, there is no FICA tax liability. Also, there is no Social Security or self-employment tax liability for a child (of any age) if the child is paid for farm services with agricultural commodities.
Example: A parent owns a sole-proprietorship business. The parent decides to hire a 15-year-old child to clean the business premises. The child was paid a reasonable wage of $4,000 per year and encouraged to save the earnings for future college costs. Since the parent was in a combined 41% tax bracket (federal 35% + state 6%), the $4,000 in wages saved $1,640 (41% x $4,000). Since the child’s taxable income would be zero ($4,000 wages – $6,300 standard deduction), there would be no tax on the wages. Therefore, the total family tax savings would be $1,640 per year
Income earned from work by a child under age 18 increases the child’s standard deduction from $1,050 to a maximum of $6,300 in 2017.
For other businesses owned by the parent, smaller salaries (less than the child’s standard deduction amount of $6,300 for the year 2017. can be income tax free to the child, but will incur a 15.3% FICA tax. Salaries greater than the standard deduction will cause both 10/15% income tax and 15.3% FICA tax, and are only efficient for upper bracket businesses/parents.
In addition to the tax saving benefits of hiring a child, the child would be eligible to save for college (because of the earned income) by purchasing IRAs (either Roth or regular IRAs). The tax-deferred growth over a long term can result in very substantial accumulations when the child reaches college age. The Roth IRA may be the best type of IRA to use because the original contributions may be withdrawn tax and penalty free for college expenses. If the child has other unearned income which is creating income tax, a traditional IRA should be considered.
Shifting by Giving Assets That Earn and Grow
For affluent parents with no appreciated assets or family compensation opportunities, the remaining strategy is to shift after-tax dollars to the child as early as possible by annual gifts, so that the growth and earnings on the investments are taxed at the child’s rates rather than parental rates.
In general, the strategy should be to defer all investment income to college years, on the premise that the college student’s tax return can report this deferred income tax free for three reasons:
- The child claims his or her own personal exemption.
- The child, as a non-dependent, receives a full standard deduction.
- The child may claim either the American Opportunity Credit or the Lifetime Learning Credit for tuition expenditures.
Exceptions to the general strategy of deferring investment income to college years would include:
- Reporting up to $1,050 per year of taxable investment income (tax free due to offset by the dependent’s standard deduction).
- Recognizing appreciated stock sales, or appreciated grain gift sales, where it is necessary to use multiple tax return years of the child’s lower tax rate capacity (e.g., spread $100,000 of appreciated stock gains into four tax returns of the child to achieve 5% capital gain reporting; if sold in a single year, most of the gain would be taxed to the child at 15%).
Use of a custodial account is the most common method of shifting income and assets to a child. These accounts are simple and inexpensive to establish. The custodian of the account is responsible to see that the account assets are spent for the benefit of the child. This method of income-shifting could be utilized by clients who want to keep the control of the asset out of the child’s hands until the child is 18 or 21 years of age. Clients can reduce their estate and provide a college fund for the child by using a custodial account. If the client is giving a small or moderate amount of assets to the child and does not want the high administrative costs associated with trusts, a custodial account should be considered.
Advantages of using custodial accounts:
- They are simple and inexpensive to establish and administer.
- Control of the assets is kept from the child until age 18 or 21.
- Contributions are eligible for the annual $14,000 gift exclusion.
Disadvantages of using custodial accounts:
- The donor loses control of the asset (but may serve as custodian).
- The assets must be distributed to the child at age 18 or 21.
- The assets must be used for the benefit of the child and not parental support items.
- Under age 24 the “kiddie tax” rules may cause the income to be taxed at the donor’s tax rate.
Other Income Shifting Strategies
Gifts of Business Interest
There are other income-shifting techniques that may be employed by the client to shift income to the child, such as:
- Gifts of S Corporation stock
- Gifts of Limited Liability Company interests
- Gifts of family partnership interests
- Gifts to a Qualified Personal Residence Trust
The financial advisor can advise the client to adopt income shifting strategies to maximize a child’s tax capacity. The advantages and disadvantages of the investments used to hold the assets shifted to a child need to be considered by the financial advisor. The timing of the distributions for college costs also needs to be considered by the financial advisor.
S Corporation to Shift Income
Gifts of stock in a family Subchapter S corporation can be used to shift income to children and reduce the parents’ estate. The child does not have to contribute income-producing capital to obtain a legitimate stock ownership. If the child is a minor, the stock can be held in a trust (a Qualified Subchapter S Trust or an Electing Small Business Trust) or custodial account (UGMA/UTMA). If the child is a student under age 24, the child’s Subchapter S corporation income will be subject to the kiddie tax rules.
- The child can use income from the stock to fund college.
- The parent has control while stock is in trust or custodial account.
- The value of the stock will be considered a gift and will be eligible for the annual gift exclusion.
- The stock will be removed from the gross estate of the donor.
- If the child is under age 24, the S corporation stock income allocated to the child will be subject to the “kiddie tax” rules. S stock held in either a custodial account or a Qualified Sub S Trust (QSST) will pass income through to the child. S stock held in an Electing Small Business Trust (ESBT) does not pass through income to the beneficiary, but the trust is taxed at a flat 35% on S income.
- When the trust or custodial account terminates, the child will have complete control of the stock and income generated from the stock.
- The stock may produce more income than the child needs for college.
- How will the stock be redeemed or reacquired by parent? a) Stock redemptions within 10 years of a gift of the stock are converted to dividend status per IRC Sec. 302(c)(2)(B)(i). b) This produces ordinary dividend income to the shareholder if S Corporation has former C Corporation earnings and profits (E+P). b) This produces an S distribution (an extraction of the AAA account and tax-free return of basis) if S has no E+P.
- If the taxpayer has several children, gifts of family S Corporation stock to all children can result in long-term divergence of stock ownership vs. employment/ management roles (e.g., three children own some portion of S Corporation but only one child is an active employee/successor owner).
Limited Liability Company to Shift Income
A Limited Liability Company (LLC), because of its tax status as a partnership, provides great flexibility in allocating interests in profits and capital and therefore can be used to shift income to children and grandchildren. There are generally no restrictions on the type of assets that can be used to fund a family LLC. The assets could be stocks, real estate, business assets, or interests in partnerships.
The income shifted to the child could be used to fund college with no loss of control. A LLC allows the management of the business to be concentrated in the hands of one manager or just a few managers without causing the transferred interest to be included in the owner/manager’s estate.
- Provides flexibility in allocating profits to the child.
- No restriction on the type of assets that can be used to fund the LLC (although the IRS will contest the use of discounts in valuing LLC units where the LLC holds marketable securities).
- Control over the assets can be kept by the managers (parents).
- Income is shifted from the donor of the LLC interest to the child.
- The value of the LLC interest is a gift to the child and is eligible for the annual gift exclusion, with the possibility of discounted valuation of the LLC interests due to minority status and lack of marketability.
- The value of the LLC interest will be removed from the donor’s estate.
- The child’s income will be subject to the “kiddie tax” rules if the child is under age 24.
- The child has an ownership interest in the LLC. Is the parent objective to have the child permanently own this interest? If not, an eventual acquisition plan or redemption strategy is required.
- More income than the child needs for college may be generated.
Family Partnership to Shift Income
Typically, a family limited partnership has the parent as the general partner and the children as limited partners. The limited partners cannot make investment, business, or management decisions. The parents make annual gifts of limited partnership interests to a child. The tax savings and income from the partnership are used to fund the child’s college education while the parents keep control of the underlying assets.
- The income generated from the child’s share of the partnership is taxed at the child’s lower rates.
- If the parents are the general partners, they control the amount of distribution to the child.
- The value of the partnership interest is a gift to the child and is eligible for the annual gift exclusion (with the possibility of discounting the valuation of the minority limited partnership interest).
- The value of the partnership interest will be removed from the donor’s estate.
- The child’s income is subject to the “kiddie tax” rules if the child is under age 24.
- The child has an ownership interest in the business. Does this make long-term business sense, especially if the child is expected to be inactive in the business? How does the child eventually sell this asset and to whom?
- More income than the child needs for college may be generated.
Qualified Personal Residence Trusts for a Vacation Home
A QPRT is created when a client transfers his residence into a trust and retains the right to use the residence for a specific number of years (Reg. 25.2702-5). At the end of that time, the residence is transferred to the client’s beneficiaries/children. When the children receive the residence, they can use the rent or sale proceeds to pay for college costs. When the residence is transferred to the trust, a taxable gift is made, but the value of the gift is discounted for the present value of the donors retained period of usage.
Often, beneficiaries purchase life insurance on the grantor’s life to insure against the risk that the residence will be returned to the estate if the grantor dies during the term of the QPRT. The life insurance proceeds can be used to pay the additional estate taxes should the grantor die.
- The children can sell the house or rent the house out and use the proceeds for college.
- The value of the gift is the present value of the residence. Therefore, the value of the gift depends on the value of the residence, the term of the trust, and the applicable federal interest rate (AFR) in effect at the time of the gift.
- The residence plus any future appreciation is removed from the donor’s estate.
- During the term of the trust, the grantor/parent retains grantor trust income tax treatment (i.e., tax deductibility of real estate taxes).
- Beneficiaries acquire the residence with the same tax basis as the grantor.
- The beneficiaries cannot use the $500,000 exclusion for the sale of a personal residence.
- The parents will have to pay rent if they live in the house after the expiration of the trust term. This rent is non-deductible to the parents, but taxable to the children!
Investments for Deferring Income to College Years
There are several investments to defer income to college years. One or a combination of these investments may be used to defer income on investments made for the child of an affluent parent. The following investments will be discussed in this section:
- Coverdell Education Savings Accounts
- Qualified Tuition Plans
- I Bonds
- EE Bonds
- Traditional IRAs/SIMPLE IRAs
- Roth IRAs
- Tax-Efficient Funds
- Life Insurance
- Real Estate