If income from an irrevocable trust is neither distributed nor required to be distributed to a child, it will not be included in the childs income for the year. Therefore, through the use of a trust the tax capacity of the child can be increased by an additional $2,400; the first $2,300 of trust income is taxed at 15% plus the $100 trust exemption. As a result, by transferring some assets to a trust and some assets to a child, the tax capacity of the child can be increased to $4,300 of unearned income, $1,900 plus $2,400. If the parents are in a tax bracket higher than 25%, there will be some tax savings even if some of the income of the trust is taxed a rate higher than 15%.
A client who is in the 25% tax bracket transfers bonds to a child that will provide the child with $1,650 of taxable interest. If the child has no other income, the child will pay a tax of $70 on this interest income, 10% of $1,650 less the standard deduction of $950. The client also transfers bonds to an irrevocable trust for the benefit of the child, which will produce $1,900 of interest income to the trust. The trust is required to accumulate all income until the child reaches the age of 18 when the accumulated income will be distributed to the child. The trust will pay a tax of $270 per year on its taxable income, 15% of $1,900 taxable income. The total taxes on the unearned income of the child and the childs trust will be $340 per year, $70 plus $270, on the total unearned income of $3,450. This will be $523 per year less than the $863, 25% of $3,450, which the client would have to pay on the income if it were taxable to the client.
By using a trust, you may be able to increase the amount of income that you can shift to your child and still avoid the Kiddie Tax. If you are in a combined (federal, self-employment, and state) tax bracket of 30%, you could reduce your taxes up to $300 for every $1,000 of income shifted to your child by using a trust to increase your childs tax capacity.