The American Opportunity Credit provision that was part of the recent stimulus legislation increased the Hope Tax Credit from $1,800 per student for the first two academic years to $2,500 per student for four academic years. Although this provision is scheduled to expire at the end of the 2010 tax year, it is widely believed that it will be extended or made permanent. The income phase-out ranges were also raised, from a range of $100,000 to $120,000, to a range of $160,000 to $180,000 of modified adjusted gross income on joint tax returns. Affluent clients will typically still be in the phase-out range, but the child can claim the credit on her own tax return as long as the criteria outlined above are met.
Avoiding The Kiddie Tax
The
kiddie tax is a tax on unearned income paid to minors. For 2009, the
first $950 of such income is tax free, the second $950 is taxed to the
child at his or her tax rate and all unearned income over $1,900 is
taxed at the parents' tax rate. The kiddie tax rule now applies to
children under age 19 and full-time college students under the age of
24.
In 2009, the only way that college students under age 24 will be able to avoid the kiddie tax is if they provide over half of their own support from their own earned income-wages and salaries, but not income from selling stocks. Notice that this is different from the support test for the personal exemption mentioned above, which allows the student to use their earned income in addition to their unearned income and personal assets to pass the test.
Breaking It Down
As
an example, let's assume your client hires his daughter to set up and
administer a new computer network for the family business and pays her
$17,000 per year. We will also assume that your clients have been
gifting their daughter appreciated assets over the years and that she
will sell some of the assets during each year of college and realize
$26,000 in annual capital gains. She will use the proceeds from the
sale of assets in combination with her $17,000 of earned income to pay
for the full cost of her first year at Penn State University, the
University of North Carolina at Chapel Hill, the University of Texas or
some other flagship state university with a total cost of attendance of
around $33,000 per year, including out-of-state tuition.
The daughter will be able to take advantage of the standard deduction, the personal exemption and the Hope Credit to offset her $17,000 of earned income and $26,000 of unearned income each year.
The standard deduction of $3,650 and the personal exemption of $5,700 get applied against her earned income of $17,000 first, leaving a remaining earned income of $7,650, which is taxed at 10%, for a total of $765. Combined with her capital gains, it leaves her with a net taxable income of $33,650.
A key component to the overall strategy is that, because the daughter was able to provide more than half of her support from her earned income, she avoids the kiddie tax, which means that her long-term capital gains will be taxed at the regular capital gains tax rates.
The current long-term capital gains tax rate is 15% for taxpayers in the 25% tax bracket and above but, for 2009 and 2010, the rate is 0% for taxpayers in the lower 10% and 15% brackets for regular tax purposes. Her net taxable income of $33,650 falls in the 15% tax bracket for single taxpayers, which means that her capital gains tax rate is zero percent from now through the 2010 tax year.
The Hope Credit will eliminate her overall federal tax of $765 and because 40% of the Hope Credit is now refundable to a maximum of $1,000, she will actually get a refund of $1,000. The refund would not be available to her if she was claimed as a personal exemption on her parents' tax return, but since she passed the support test for the exemption, she is eligible to claim a refund because she didn't use all of the Hope Credit.
Assuming her parents are in the 35% tax bracket, they would have paid $9,850 in federal taxes on the combined capital gain and earned income each year of college if they had not implemented this income-shifting strategy.