Children can reap great benefits from internships, co-op education programs and work study programs, which not only help them establish tax independence, but also give them much needed job skills, a competitive edge that will help them after college.

One of the things keeping parents from shifting unearned income to a dependent full-time student under the age of 24 is the so-called kiddie tax. Under this tax, only $1,900 of a child's investment income escapes the parent's higher tax rate. But the tax does not apply to income earned by a student working part time or during summer vacation. If the student's earned income exceeds one half of his or her support, the kiddie tax no longer applies at all. Nor would the tax apply to qualified income-tax-free withdrawals from the student's 529 college savings plan.

Tuition Assistance Program
Since Mike Miller owns a small ad agency, he might want to consider hiring his children when they are of legal age under state law. Doing so will shift some income into the offspring's lower bracket and help them qualify as tax independent. Mike may also want to consider implementing a tuition assistance program (IRC Section 127), whereby he can provide up to $5,250 per year in tax-free reimbursements for tuition, books and supplies, even if the courses are non-job related. Tuition assistance program payments are a tax-free fringe benefit to the employee and a deductible business expense to the employer.

A tuition assistance program can only be offered to employees, must be in writing and cannot discriminate in favor of highly compensated employees. Therefore, the children will have to be legitimate employees and the plan will have to be liberally drafted to include them despite their part-time status. Mike will probably know whether any of his other employees are likely to take advantage of this benefit and will have to weigh the possible additional expense before implementing the program.

Tax Credits
Establishing the children as tax independent students may also make them eligible for tax credits for which the parents don't qualify.

The Hope Scholarship Credit is a non-refundable credit against an individual's federal income tax liability. The maximum credit is $1,800 per year.  This means that the taxpayer has to owe at least $1,800 in federal income tax to use the full value of the credit. (The American Opportunity Tax Credit is a temporary expansion of the Hope Tax Credit as part of the economic stimulus package enacted in February 2009. But the American Opportunity Tax Credit is only valid for tax years 2009 and 2010. For those years, taxpayers can get up to $2,500 to help pay for up to four years of college for each student.) Because of phase-out rules, Mike and Becky would be ineligible for this credit, whereas their tax independent children would probably qualify.

The Hope Scholarship Credit can only be used for undergraduate tuition and fees, but these expenses do not have to actually be paid by the student. The parents or grandparents can make the payment directly to the educational institution and the student gets credit for the payment. The grandparents in our example may want to make an occasional tuition payment for their grandchildren.

The Lifetime Learning Credit has a higher $2,000 maximum, but is calculated based on 20% of qualified tuition expenses. If the student is attending school on a part-time basis, the Hope Scholarship Credit may give them a higher tax credit. The Lifetime Learning Credit can also be used for graduate or professional degree programs.

529 Plans
While parents can control the timing of withdrawals from a 529 college savings plan, an important feature for an affluent family is that the withdrawals are considered to be the child's income for purposes of establishing tax independence. In addition, 529 plan withdrawals for qualified education expenses are income tax free and can be excluded from income in the same tax year that a Hope Scholarship Credit or Lifetime Learning Credit is claimed. The 529 plan withdrawals cannot, however, be based on the same expenses as education credits; no double counting. But this is usually not a problem since the 529 deduction is available for a much broader array of education costs.

Application
Let's go back to the Miller family. Assume for a moment that their oldest child, Scott, is now a freshman in college. Scott earns $12,000 working for his father's advertising agency over the summer months, during holiday vacations and on the occasional weekend during the school year. From investment assets that his parents transferred to him by way of an account set up according to the rules of the Uniform Transfer to Minors Act, he earns $1,750 in interest. His grandparents make a $5,000 tuition payment on his behalf direct to the university. His parents distribute $10,000 from a 529 college savings plan and his father $5,250 from his company's tuition assistance program for a total of $34,000. The $12,000 of earned income, $1,750 of interest earnings and $10,000 of 529 plan monies ($23,750 in total) all count toward Scott being independent for income tax purposes.