Unearned income for children

I got a late start saving for college for my two children, ages 17 and 15. I am currently unincorporated, but I plan to incorporate my practice as a Subchapter S corporation...

I got a late start saving for college for my two children, ages 17 and 15. I am currently unincorporated, but I plan to incorporate my practice as a Subchapter S corporation effective Jan. 1, 2007. Should I transfer my equipment into a trust or partnership for the benefit of my children and then lease it back to my corporation? Or would putting some appreciated stocks and/or real estate into my children’s name - and then having them sell it - be better for college funding?

Recent tax law changes under the Tax Increase Prevention and Reconciliation Act affect this strategy. Ironically, this act actually increases taxes for your children.

Under prior law (2005), unearned income for children aged 14 or older was taxed at their lower rates (10 percent and 15 percent), rather than at the parents’ rate. Under the new law, unearned income for children under 18 is now taxed at the parents’ rate.

Accordingly, you could transfer the equipment into a family limited partnership effective with your incorporation, and thereafter lease back the equipment to your professional corporation under a five-year lease. In order to gain maximum tax advantage, you may wish to pay less rent in the early years of the lease and more rent in the later years, so that more of the income is taxed at lower rates once the children reach age 18.

In addition, you could transfer appreciated property (stocks and/or real estate) to your children at age 18. They could then sell these assets, with all capital gain taxed to them at their rate, which may be as low as 0 percent in 2008-2010.

You should consult with your tax advisor to help design a strategy to maximize the tax savings for your family, based upon the amount of college funds needed and the value of your personal assets.

I heard that the 15 percent maximum tax rate on capital gains and dividends is being phased out in 2008. Is this correct?

No. President Bush recently signed into law the Tax Increase Prevention and Reconciliation Act, which extended the 15 percent maximum tax rate on dividends and capital gains through 2010.

While this is the maximum tax rate under the law, in some cases doctors’ family members may pay a 0 percent rate on capital gains and dividends. That’s because the law extends through 2010 a little-known provision that eliminates capital gain taxes on taxpayers (including children, grandparents, etc.) who are in the lowest tax brackets (10 percent and 15 percent) for years 2008 to 2010. For tax years 2006 and 2007, these lowest-bracket taxpayers pay tax on capital gains and dividends at only a 5 percent rate.

My 15-year-old reported $5,000 in income this year, solely from capital gains on the sale of stock that we held in a custodial account for her. I wanted to use a portion of the funds to contribute to a Roth IRA for her, but my accountant says I cannot do this. Is he correct?

Yes. In order to qualify for a Roth IRA contribution, your daughter must have earned income from services rendered. Unearned income, such as interest, dividends, and capital gains from the sale of stock, does not count. Accordingly, your daughter cannot fund a Roth IRA contribution unless she has earned income for the year.

While my income is too high to be eligible for a Roth IRA contribution, I have funded a regular nondeductible IRA with after-tax dollars each year, so that I can take advantage of the tax-deferred compounding and pay tax only on the earnings generated when withdrawn. My accountant says this is no longer a good idea. Is he correct?

No. A recent tax law change adds significant luster to making nondeductible IRA contributions. Under the Tax Increase Prevention and Reconciliation Act, doctors can convert their existing IRA balances into Roth IRAs in 2010, regardless of their income level. While taxes will be due at the time of the conversion, future Roth earnings will be tax-free forever.

Under current law, doctors can convert their regular IRA to a Roth IRA only if their income does not exceed $100,000. Accordingly, funding a nondeductible IRA makes more sense now to take maximum advantage of the future Roth IRA conversion.

John K. McGill is a tax attorney, CPA, and MBA, and is the editor of The McGill Advisory, a monthly newsletter helping dentists to maximize profitability, slash taxes, and protect assets. The newsletter ($209 a year) and consulting information are available from John K. McGill and Company, 2810 Coliseum Centre Drive, Suite 360, Charlotte, NC 28217. Call (704) 424-9780 or visit the Web site at www.bmhgroup.com.

More in Science & Tech