Family & Dependents

"Don't get confused: The child credit is in addition to the child care credit and in addition to the tax savings delivered when you claim an exemption for a dependent child"
-Howard Choder

Child Credit
Don’t get confused: The child credit is in addition to the child care credit and in addition to the tax savings delivered when you claim an exemption for a dependent child. Each child under the age of 17 qualifies for a $1,000 (if your income is below threshold).  If you have four children, the credit can cut your tax bill by $1,000.  Remember, a credit offsets your tax bill dollar for dollar.

The right to the child credit is phased out at higher income levels and, despite a lot of talk, Congress did not increase those levels. The phase-out begins when adjusted gross income (AGI) passes $110,000 on a joint return, $75,000 on a single return or $55,000 if you’re married filing separately. For every $1,000 (or fraction of $1,000) your AGI exceeds the trigger point, you lose $50 of credit. Say, for example, that you file a joint return and your AGI is $105,000. The $5,000 over the threshold would squeeze your credit by $250. If you have just one dependent child in 2016, your credit would be just $350. If you have three children who qualify, though, your credits would be worth $1,550 ($1,800 – $250). The phase-out moves in $50 steps, not $50-per-child steps.

Give Away A Tax Bill
Another way children can help cut the family tax bill is with gifts of appreciated securities. If you give a child stocks or mutual fund shares that have appreciated, for example, the tax bill on the increase in value is passed on to the recipient along with the gift. Assume that stock you bought for $2,500 is now worth $5,000 and that you have a tuition bill coming due. If you sold the stock, you’d owe tax on the $2,500 gain. The 15 or 20% rate on long-term capital gains means that would cost you $375/500. Not bad, perhaps, but there’s a way to cut the bill in half. . .or maybe even drive it lower.

How? By giving the shares to your college student. When sold, the same $2,500 would be taxed, but at the child’s rate (assuming he or she isn’t a prodigy who has started college before age 14). If he or she falls in the 15% bracket, the 10% long-term capital gains rate would apply and the tax bill would be $250. Don’t think your child has to hold on to the stock for more than 12 months to get special capital gains treatment, either. When gifts of appreciated asset are involved, the recipients holding period includes time that the donor owned the property.

What if you didn’t really want to part with the stock? You could always reinvest in the shares with the cash that otherwise would have gone for tuition. You’d be taxed only on appreciation from that time on. (Take care not to let this strategy cost you a dependency exemption, which it could if, with the gift money, the child winds up supplying more than 50% of his or her support.)

All this attention to generosity demands a brief mention here about the federal gift tax. The law permits you to give up to $14,000 each year to any number of people without having to worry about the gift tax. If you’re married, you and your spouse can give up to $28,000 each year to each person on your gift list. Gifts above those levels are subject to the gift tax. When it comes into play, this tax is imposed on the giver of gifts, not the recipient. And, since there’s a credit to offset the tax on the first $5 million of taxable gifts in 2014 and later years, it’s doubtful you’ll ever have to pay a dime in gift taxes.

Children, College, and the “Kiddie Tax”

Despite various crackdowns, income splitting can still save your family money. If you’re planning to help pay for your children’s college education, starting to give them the money for tuition long before the first bill comes due can still get Uncle Sam to help pay the bill.

Remember that the first $2,000 of unearned income escapes the kiddie tax in 2014. A child could have $33,000 in an account yielding 6% without having to worry about the kiddie tax. If that $2,000 is the child’s only income in 2014, the tax bill will be just $75 (the first $750 is tax free, the next $750 taxed in the new, 10% bracket). If the same $2,000 were taxed in the parents’ 35% bracket, for example, the tax would be $700. The $450 savings is the IRS contribution to the college fund.

Since the kiddie tax disappears when a child reaches age 14, consider giving your kids investments that defer income until that time.

U.S. savings bonds are a natural choice because income can be deferred until the bond is cashed. If that’s after the child reaches 14, even the interest that accrued during his or her younger days is taxed at the child’s own rate. However, a recently added tax-saving twist for savings bonds could make it a better deal to buy the bonds in the parent’s name rather than making the child the owner. When parents own the bonds and cash them in to pay a child’s college tuition and fees, the interest on the bonds can be totally tax-free.

Growth stocks, which generally throw off little if any current income in the form of dividends, are another way around the kiddie tax. As the stock appreciates, there is no tax on that paper profit. If the stock is sold after the child is 14, the profit is taxed in the child’s bracket. Note that if a child invests in growth-stock mutual funds, rather than individual stocks, the fund will pay out capital-gains distributions each year based on trading within the fund. Such income would be subject to the kiddie tax if the child’s unearned income exceeds $2,000 in 2014.

For income splitting to work, the child must actually own the assets that generate the income. If you want your son to pay taxes in his bracket on $1,000 of interest income generated by a $15,000 savings account, you can’t simply give him the $1,000. You’ve got to give him the $15,000 in the account. Only then will the income it produces be his for tax purposes.

The easiest way to make such a gift to a minor child is to set up a custodial account under your state’s Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA). Banks, savings & loans, credit unions, mutual funds and brokerage firms offer such accounts. All you need is a Social Security number for the child and a custodian to manage the account until the minor comes of age. You can name yourself custodian, but if you are also the donor and you die before the child reaches maturity, the gift will be considered part of your estate for federal estate-tax purposes.
An important point about custodial accounts is that your gift is irrevocable-you can’t get it back. Once the child reaches the age set by your state’s UGMA or UTMA law-typically 18 or 21-adult supervision of the account ends and the child can do anything he or she wants with the money. If sandy beaches are more enticing than ivy-covered walls, well.

You don’t need a custodial account if you invest the child’s money in U.S. savings bonds. Just buy the bonds in the child’s name. Don’t name yourself co-owner, though, or the income will still be taxed to you when the bonds are cashed.

Buying Property for Your Kids to Live in During College
Here’s another income splitting/real estate combination that some parents have found a valuable help in paying for a child’s college education. They pull together the down payment for a house or condo in the college town. The child gets a roommate or two and they all pay rent to the parents, who report it as income but also get to deduct mortgage interest, property taxes and depreciation.

The parents also hire their child to manage the apartment-finding tenants, collecting rents, taking care of maintenance and repairs. What they pay him or her is deductible from the rental income. If the rental property shows a loss, and if the parents qualify for the $25,000 exception to the passive-loss rules, that loss can shelter other income. Any profit when the home is sold after graduation is an added sweetener.

Hiring The Family
If you have your own business-either full- or part-time-you have another income-splitting opportunity. Put your children on the payroll, working in the evenings and on weekends during the school year and during the summer. What you pay them is a business deduction for you and earned income for them. That shifts income out of your tax bracket and into the child’s. Because it’s earned income, the kiddie tax doesn’t come into play.

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Loans to Family Members
With today’s house prices, this is an increasingly probable scene: Your son and his wife come over for dinner, fill the air with friendly chitchat and finally mumble sheepishly what’s really on their mind: They’ve found their dream house and need help with the down payment.

No, they’re not so brash as to ask for a $20,000 gift. Just a loan. A loan with very lenient terms-like low, low interest rates (check the applicable Federal Rate) and an extremely flexible repayment schedule.

As you discuss the request, be aware that Uncle Sam may want to horn in on this congenial family scene. The government’s interest in intrafamily loans stems from having been burned by no-interest loans designed to dodge taxes. Wealthy parents could “lend” money to a child in a low tax bracket and, in the best of income-splitting traditions, the child would invest the money so the income would be taxed at the child’s lower rates. That loophole has been closed.

The law now treats such loans as though the lender is charging interest on the deal and simultaneously making a gift to the borrower of the amount needed to pay that interest. This fiction has a very real tax consequence: The lender has to report as taxable income the phantom interest the loan did not produce. What’s more, if the amount of foregone interest exceeds $10,000, the lender may be liable for federal gift taxes.

Don’t turn down your kids’ request straightaway, though, because-as usual-there are exceptions that can protect your intrafamily loan from the IRS.

If the amount of the loan outstanding at any time is $10,000 or less, the IRS will ignore it. Under that test, husband and wife are considered to be one lender and the $10,000 limit applies.

A second exception protects even bigger low-interest or even interest-free loans. For loans up to $100,000, the IRS won’t get involved as long as the borrower’s investment income is less than $1,000. If it goes over $1,000, the forgone interest to be reported by you and deducted by the borrower is limited to the amount of the borrower’s investment income.

In other words, you can go ahead and lend your children $20,000 interest-free for their down payment, but they’d better use most of their own savings, too. If their investment income for the year surpasses the $1,000 threshold, your friendly arrangement could be stung by the imputed-interest rules.

Both the $10,000 and the $100,000 exceptions are voided if the purpose of the loan is to save taxes. If the borrowed funds are used to acquire income-producing assets, for example, the loan automatically falls victim to the imputed-interest rules. That doesn’t block loans for such purposes as a house down payment, college tuition or to help a child start a business.

If you make a loan that fails to meet one of the exceptions, the amount of imputed interest on the deal is based on IRS-set rates that reflect what it costs the government to borrow money. These “applicable federal rates” are adjusted periodically. In the Fall of 2014, the long-term AFR was about 2.97%. Call your local IRS office to learn the current AFR or check it out at the IRS website: If you charge a low interest rate, rather than no interest, the imputed interest is the difference between what you actually charge and the amount due using the prevailing applicable federal rate.

Death in the Family
When a taxpayer dies, a new taxpaying entity-the taxpayer’s estate-is born to make sure no taxable income falls through the cracks. Income is taxed either on the taxpayer’s final return, on the return of the beneficiary who acquires the right to receive the income, or, if the estate receives $600 or more of income, on the estate’s income tax return.

The chore of filing the taxpayer’s final return usually falls to the executor or administrator of the estate, but if neither is named, a survivor must do it. The return is filed on the same form that would have been used if the taxpayer were still alive, but “deceased” is written after the taxpayer’s name and the date of death entered on the name-and-address space. The filing deadline: April 15 of the year following the taxpayer’s death.

Only income earned between the beginning of the year and the date of death should be reported on the final return. For taxpayers who use the cash method of accounting, as most do, income is considered earned as it is actually received or at least made available to them. Taxpayers who use the accrual method of accounting, on the other hand, count income as earned when they actually earn it, regardless of when it is received.

The distinction is important because some income that might logically seem to belong on the decedent’s final return is considered “income in respect of a decedent” and is taxable either to the estate or to the person who receives it. Consider these examples.

  • Joe Jones owned and operated an orchard. He used the cash method of accounting. He sold $2,000 worth of fruit to a customer but did not receive payment before his death. That amount is not reported on Joe’s final return. When the estate was settled, payment had still not been made and the right to receive it went to Joe’s niece. When she collects the money, she will report it as taxable income.
  • If Joe had used the accrual method of accounting, the $2,000 would have been considered earned on the date of the sale and therefore included on his final return. His niece would not have to include the money on her return when the payment was actually received.
  • Mary Smith was entitled to a large salary payment at the date of her death, to be paid in five annual installments. Her estate collected two payments and then gave the right to the remaining three payments to her grandson. None of the income would be included on Mary’s final return. The estate would include in its taxable income the two payments it received. Her grandson would include the other three payments in his taxable income-as income in respect of a decedent-on the returns for the years he received the money.

Income in respect of a decedent encompasses only income that the decedent had a right to receive at the time of death but that is not reported on the final return. It does not include earnings on savings or investments that accrue after death.

Say a taxpayer who has a substantial amount in money-market mutual funds dies June 30. Only interest earned up to that date would be reported on the final tax return. Earnings after that date are taxable to the beneficiary of the account or the estate. That can create some hassles since the payer-a mutual fund, bank or broker, for example-will report income to the IRS on a 1099 form.

Although you should try to get ownership of the account changed as quickly as possible after the death of the owner, the 1099 income report may well show more income assigned to the decedent than it should. In such cases, you must report the entire amount on Schedule B of the decedent’s return and then deduct the amount that is being reported by the estate or other beneficiary who actually received the income.

Remember that money you inherit is generally not subject to the federal income tax. If you inherit a $100,000 certificate of deposit, for example, the $100,000 is not taxable. Only interest on it from the time you become the owner is taxed. If you receive interest that accrued but was not paid prior to the owner’s death, it is considered income in respect of a decedent and is taxable on your return.

A major exception to the general rule that inheritances are not subject to the income tax-and one that is taking on more and more importance-is that money in regular IRAs, company retirement plans including 401(k)s and 403(b)s, and annuities is treated as income in respect of a decedent and therefore taxed to the heir who receives it.
There’s a special rule for U.S. savings bonds, income on which generally accrues tax-free until the bonds are cashed. When the bond owner dies, the accrued interest may be treated as income in respect of a decedent. In that case, the new owner of the bonds becomes responsible for the tax on the interest accrued during the life of the decedent. (The tax isn’t due, however, until the new owner cashes the bonds.)

Alternatively, the interest accrued up to the date of death can be reported on his or her final tax return. That could be a tax-saving choice if the decedent will be in a lower tax bracket than the beneficiary. If that method is chosen, the person who gets the bonds includes in his or her income only interest earned after the date of death.
On the deduction side of the ledger, all deductible expenses paid before death can be written off on the final return. In addition, medical bills paid within one year after death may be treated as having been paid by the decedent at the time the expenses were incurred. That means the cost of a final illness can be deducted on the final return even if the bills were not paid until after death.
If deductions are not itemized on the final return, the full standard deduction may be claimed, regardless of when during the year the taxpayer died. Even if the death occurred on January 1, the full standard deduction is available. The same goes for the taxpayer’s personal exemption.

If the taxpayer was married, the widow or widower may file a joint return for the year of death, claiming both personal exemptions and the full standard deduction and using the lower joint-return rates. A joint return is usually filed by the executor, but the surviving spouse can file the return if no executor or administrator has been appointed.
If an executor or administrator is involved, he or she must sign the return for the decedent. When a joint return is filed, the spouse must also sign. When there is no executor or administrator, whoever is responsible for filing the return should sign the return and note that he or she is signing on behalf of the decedent. If a joint return is filed by the surviving spouse alone, he or she should sign the return, and write “filing as surviving spouse” in the space for the other spouse’s signature.

If a refund is due, there’s one more step. You must also complete and file with the final return a copy of Form 1310, Statement of Person Claiming Refund Due a Deceased Taxpayer. Although the IRS says you don’t have to file Form 1310 if you are a surviving spouse filing a joint return, you probably should file the form anyway to head off possible delays.
If the person filing the final return is the decedent’s court-appointed representative, he or she must attach a copy of the form certifying the appointment. When a return calling for a refund is filed by anyone other than a court-appointed representative or a surviving spouse filing a joint return, Form 1310 must also be accompanied by a copy of the taxpayer’s death certificate or other proof of death.