Babies and Taxes
Baby, Oh Baby!

Child Tax Credit

The Child Tax Credit is one of the key elements of the overall tax reduction provided for in the Taxpayer Relief Act of 1997. While this credit doesn't kick in until 1998, you should be aware of it to assist you with tax planning in future years.

In 1998, you may be entitled to claim a credit of $400 for each qualifying child. Starting in 1999, the credit increases to $500 per qualifying child. For example, a taxpayer with four qualifying children will be entitled to a credit of $1,600 next year and $2,000 in 1999 and later years. A qualifying child is a child under the age of 17 for whom you can claim a dependency exemption and deduction, and who is your child or other direct descendent, or a stepchild or eligible foster child. Although you must be entitled to a dependency deduction for the child, that deduction (adjusted annually for inflation is $2,650 for 1997) isn't reduced or otherwise modified because of the new child tax credit.

Remember: This is a tax CREDIT… a direct reduction of tax on a dollar-for-dollar basis… and not a simple deduction that reduces your tax on a percentage basis depending on your individual tax rate. The Child Tax Credit will be very valuable for many of you with children.

The Bad News: The credit is phased out for certain higher income taxpayers. Specifically, the amount of the credit allowable is reduced by $50 for each $1,000 (or portion of $1,000) of modified adjusted gross income (generally the dollar amount shown on the last line of page 1 of your individual income tax return) above a threshold amount. Those threshold amounts are $110,000 on a joint return, $75,000 for single filers and heads of household, and $55,000 for married individuals who file separate returns.

Huh??

Let's look at an example: Assume that it's 1998 when the credit amount is $400 per child. Jack and Jill, a married couple with one child, file a joint tax return. If their modified adjusted gross income exceeds $110,000 by as little as $1, they must reduce their $400 credit by $50. This means that as soon as their income hits $117,001, they'll lose the credit entirely. In 1999, when the credit is $500 per child, they'll lose the entire credit at a modified adjusted gross income level of $119,001.

In addition: If the otherwise allowable child tax credit is more than the amount of income tax you owe, the excess may be refunded under a formula that takes into account your share of social security taxes (FICA and one-half of self-employment tax) as well as the earned income credit.

Tax Planning Alert: To the extent that the child tax credit will reduce your 1998 income tax liability, you may want to consider a corresponding reduction in your wage withholding in 1998. For example, if you have two qualifying children and thus expect to qualify for a credit of $800 in 1998, you could reduce your withholding starting in January 1998 by about $15 per week.

So make sure that you are aware of the qualifications for this credit. With the substantial dollars involved, this is not one that you want to leave on the table.

Dependents

Let's talk dependents. For 1997 you are able to reduce taxable income by $2,650 for each dependent that you can claim on your return, regardless of whether or not you itemize deductions. Most dependents are clearly identifiable, but there may be some twists. The floor is open for questions...

Q: This one is easy. A dependent is somebody who lives with you, right?

A: Not exactly. For someone to be claimed as a dependent, they must meet all five of the following tests:

1. Support Test
2. Gross Income Test
3. Citizenship Test
4. Joint Return Test
5. Member of Household or Relationship Test

Q: OK, so what is the support test?

A: In order to meet the support test, you must:

1) provide over 50% of the total support, OR
2) provide more than 10% of the total support if the support is shared among you and others. The total shared support must be more than 50% of the total.

Q: What are some items that are included as support?

A: Things such as food, lodging, clothing, education, medical, dental, recreation, transportation, and other necessities are included as support.

Q: Does my mortgage payment qualify as support?

A: No, the fair rental value of the lodging, not the mortgage payment, is classified as support. The fair rental value is the amount the dependent would have been required to pay on the open market for comparable lodging.

Q: How about student loans and scholarships?

A: Student loan proceeds used for educational and living expenses are considered to be support provided by the individual responsible for repayment of the loan. Scholarships received by a dependent who is a full-time student for at least five months during the year are not considered support.

Q: Who should pay close attention to the support qualifications?

A: Many parents who have children with substantial other income care very much about these qualifications. We are primarily talking about college students with other outside income. Every year I have clients whose support is tracked closely so that the dependency exemption is not lost to the parents. Most people can easily meet the support test, but for many others the support question is very difficult to answer.

Q: My two sisters and I support our mother who lives alone on a small pension. Who claims the dependent exemption?

A: I alluded to this situation above, but now we can address it in detail. As long as you and your sisters each provide at least 10% of the total support, and over 50% of the total support together, and all of the other tests are met, you can decide among yourselves who will claim the dependent. Use IRS Form 2210, "Multiple Support Declaration," signed by each of you, and attach it to the return of the one who will claim the dependent. In such cases, the dependent exemption usually floats from person to person annually. But depending on your tax status and the tax status of your sisters, there are some tax planning opportunities available.

Q: What is the gross income test?

A: The dependent must have less than $2,650 of gross income in order to be claimed as a dependent.

Q: Huh? My son works part time and makes over $2,650 in wages. Would he meet the gross income test?

A: If you son is under the age of 19 at the end of the tax year, you are allowed an exemption if he meets the other dependency tests. The gross income test does not apply to children 19 years old and under.

Q: But my daughter is in college and she is over 19. She also earns over $2,650 in wages from her part time job. Would she meet the gross income test?

A: If your daughter is under age 24 and was a full-time student during at least 5 months of the year, you are allowed an exemption if she meets the other dependency tests.

Q: My son is *finding himself* right now. He is 20 years old, lives at home, doesn't attend school, and earns about $3,000 from his part time job. Certainly he must be a dependent?

A: He sounds very dependent!! And I hope that he finds himself before you go broke because you will not be allowed an exemption for him as a dependent on your tax return since he fails the gross income test. He's over 19 and not a full-time student. Sorry... invite him into Fooldom; spark his interest in stocks!

Q: I support my father who lives in Canada. Would he meet the citizenship test?

A: Yes. The dependent MUST be either a U.S. citizen, resident, national, or a resident of Canada or Mexico.

Q: My daughter is only 18 years old and got married in December. She lived with us for the entire year, but now says she wants to file a joint return with her new husband. Now what?

A: Well, the joint return test states that no exemption may be claimed for a dependent who files a joint return. But, there is an exception. If the joint return is filed only to claim a refund of tax withheld, neither spouse is required to file. No tax liability exists for either spouse if separate returns are filed; a joint return can be filed and the dependent exemption can still be claimed. The exception is very narrow, but can sometimes work. Too bad you couldn't talk her into a January wedding.

Q: What is the member of household or relationship test?

A: To meet this test, the dependent MUST:

1) live in your household for the entire year, OR
2)be related to you.

Therefore, persons closely related to you do NOT have to live in your household to meet the test.

Q: Who are closely related persons?

A: Wschoooooo (Taxes taking a deep breath)... child, grandchild, great-grandchild, adopted child, stepchild, brother or sister, half brother or half sister, brother-in-law or sister-in-law, stepbrother or stepsister, father or mother, grandparent, father-in-law or mother-in-law, stepfather or stepmother, aunt or uncle, niece or nephew, son-in-law or daughter-in-law.

Q: I have my father-in-law living in my home. Or at least he used to be my father-in-law. He is really my ex-husband's father. Since my ex and I are now divorced, would he still qualify?

A: Yes... any of the above relationships that were established by marriage are not ended by death or divorce.

Q: My mother-in-law lived with my wife and I in 1996, but she died in early January. Would she still qualify?

A: Yes again... a person who dies during the year and was a member of the household until death still meets the member of household test. In addition, a child who was born and died during the year still meets the test.

Gifts to Children

I have received many questions from parents who want to gift money to their children. Sounds easy enough, right? Read on...

Q: I want to give my children gifts of money and stock. What kind of account should I deposit the funds into? A custodian account? A UGMA account? And what are the tax consequences?

A: First, let me address the question of a custodial account vs. a guardian account. In general, under a guardian or "in trust for" account, the guardian (generally the parent), continues to be the owner of the money. The guardian can withdraw the money for any purpose, and, most importantly, remains liable for the taxes on the earnings. Under a custodial account, the child is treated as the owner of the account, but the parent still controls the investments in the account. In other words, any gains, income, or dividends on the account are taxed at the child's level. In most cases, the use of a custodial account is more beneficial for tax purposes.

Now then, you may have some "kiddie tax" issues relative to the earnings of the children. Take a look at the Kiddie Tax article here in the FAQ area in order to become more familiar with the concept of the "kiddie tax" and how it really works before you make any final gifting or investment decisions. Let's move on to the different types of custodian accounts.

There are two major types of custodian accounts: The Uniform Gift to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA).

A UGMA account is a very convenient way for high-income parents to "shift" some of their tax burden to the kids, or even save for the children's education. But it also has certain limitations:

1. It can only be used for lifetime gifts (not gifts made by a will).
2. Only certain kinds of property are covered. You are limited to making gifts of money, securities, life insurance, or annuities.

With a UGMA account, you (generally the parent) maintain control over the money until the child reaches the age of majority (18 or 21, depending on the state). Once the child reaches the age of majority, the parent no longer has control over what is done with the money.

UTMA accounts work in the same way as UGMA accounts, except that UTMA accounts let you, the parent, maintain control over the money for a longer period of time -- for example, until the child finishes college. While UGMA money is available to the child at the age of majority, UTMA accounts permit postponing distributions until age 18, 21, or 25, depending upon the state.

Also, the UTMA account, unlike the UGMA, may be invested in real estate, royalties, patents and paintings.

So who deals with UGMA and UTMA accounts? Where can you find them? Virtually every bank and stock brokerage firm (both full-service and discount) deal with these types of accounts on a daily basis. You should be able to set up the account almost anywhere.

Junior on the Payroll

If you own a Schedule C business (sole proprietorship), here's a way to get the kids a summer job and also save on taxes. A Schedule C business owner can save family income and payroll taxes by putting a junior family member on the payroll. Let's look closer.

What we are looking at here is income shifting, or bracket shifting. Shifting some of the earnings of the business to the child as wages for services rendered can reduce income and employment taxes. Obviously, the work done must be reasonable in order for the business to get a deduction, but it doesn't have to be technical or professional in nature. An example:

One of my clients, Janet, is a Certified Financial Planner (CFP), and she operates as a sole proprietor and files a Schedule C. This summer, Janet is planning on upgrading, updating, and generally cleaning up her client files. She also needs some "fill in" help during the summer in order to cover vacations, etc. Janet plans to hire her 16-year-old son, Tom, to do this work. Tom will work full-time over the summer and will earn $4,000.

Well, Janet is very successful and is in the 36% tax bracket. Tom has no other income, and the wages Tom will earn (reported on W-2 form that he will receive from Janet) will be offset by his standard deduction. Therefore, Tom's earnings are completely sheltered, and he will pay no tax on that income. Janet, on the other hand, will reduce her income by $4,000, thereby saving her $1,440 in income taxes.

And it gets better. Janet will save on social security and Medicare taxes (FICA) -- at least the Medicare portion -- and Tom's wages are not subject to FICA taxes at all. Internal Revenue Code Section 3121 clearly states that employment for FICA tax purposes doesn't include the services performed by a child under the age of 18 in the employ of his mother or father.

So in this example, Janet's SE (Self-Employment) income would be reduced by $4,000, saving at least $116 (the 2.9% Medicare portion of the FICA tax). And, if Janet is not over the FICA limit ($62,700 net earnings in 1996), she will save an additional $496 in SE taxes in 1996. The actual SE tax savings would be slightly less than shown because Janet gets an income tax deduction for one-half of the extra SE taxes if they would have been paid. But I think you can see how the numbers (and savings) work.

And remember, Tom has no FICA tax to pay, either at the employee or employer level. Nice deal, eh? Janet could save an additional $720 in income taxes (and also reduce her SE taxes) if she could keep Tom on the payroll for a longer period of time and pay him an additional $2,000. Tom could shelter this additional income by opening up an Individual Retirement Account (IRA) and making a tax deductible contribution. Also, there is a similar, but more liberal exemption applicable to FUTA (Federal Unemployment Tax) payroll taxes that can be avoided by the employer.

A few issues that you might want to consider:

---The "kiddie tax" might come into play here if your child is under age 14 and has other investment income. But remember that the kiddie tax applies only to unearned income. Earned income is not subject to the kiddie tax, and can still be sheltered by the child's standard deduction. So check the effect of the kiddie tax, if any, before and after employment income. In general, I think you'll find that a tax saving opportunity still exists, regardless of the kiddie tax issues.

---Even if all of Junior's earnings cannot be sheltered by the standard deduction and an IRA deduction, remember that Junior will still be in the 15% tax bracket, while the parent will be in a higher bracket. Even if it works out that Junior has a tax liability, that liability will probably be less (and in some cases much less) than the parent's tax liability.

---Also remember that the business can provide retirement benefits to Junior. For example, if the business has a Simplified Employee Pension (SEP), a contribution could be made for Junior up to 15% of Junior's earnings. Since Junior's adjusted gross income will probably not be in excess of the statutory amount, Junior would still be allowed to take his IRA deduction on his tax return. This amounts to a TRIPLE DIP!

But be careful about the SEP or any other retirement plans. There are many non-discrimination rules that must be followed. If you have other employees, you will most likely be obligated to cover the other employees just as you cover Junior. So unless you are prepared to do so, don't just jump right in. However, the SEP plan works very well for those Schedule C business owners who are truly sole proprietors and have no other employees to deal with, nor anticipate them in the near future.

So there you have it, you Schedule C business owners. Check this out. It might just save you some income tax and employment tax dollars.