As an investor, you may often feel like the crosshairs of government intent are often squarely aligned on your back. Targeting the wealthy has become political sport. But one of the things you have probably also noted is that many rules crafted by government to ensnare are also often ineffective. Additionally, many rules are also often symbolic; i.e. they sound good in a speech, but may be poorly thought out. They might also serve to reverse other rules that also sounded good.
With a little thought and effort, investors can structure their affairs to avoid several of these snares. One of the easier tools to use in legally creating a counter-offensive can be found in capital gains taxation. Many investors are already aware of the benefits of giving appreciated property to their favorite charities. Qualifying charities are exempt from taxation, so shifting those assets that pose a tax risk for the donor is often quite wise. But few investors are also aware that their children can provide some of same benefits. Just like a qualifying charity that has a large differential in taxation as compared to a wealthy donor, that same donor’s children also often have a much lower tax rate. In an effort to close the loopholes for shifting money to children, the IRS changed the rules in 1986, and forced income of children under the age of 14 to shift their income beyond a certain level back onto their parent’s tax return. The rules have changed again, and that age is now 24. We can clearly see the intent. However, high-earning parents are also prohibited from using the tuition tax credit. The children of those investors can use the credit if they are not claimed as a personal exemption by the parents. But since the personal exemption is also phased out for higher income parents, what’s the downside to that? None.
So say a college junior needs tuition money, for which the parent receives no tax benefit. Why not give the student a gift of low basis stock to sell and pay their own tuition? The student could receive the American Opportunity Tax Credit, currently worth $2500. That amount is precisely the tax credit needed to pay the taxes on the sale of $14,000 worth of stock (the current per parent gift limit) for which the parent paid $3500. The parent could then purchase back the same shares for $14,000 using cash, and avoid the future taxation on the $10,500 difference.
There are also much less complicated choices. The kids all get $2000 worth of tax free earnings before any income reversion to the parents takes place. So giving the stock to the kids when they are very young allows them to earn the dividends tax free, on which mom and dad would have paid taxes. The kids can also liquidate the shares when needed for college, and possibly avoid taxes again that the parents might have paid. Remember that having personal assets may impinge the child’s ability to get needs-based scholarships or financial aid. But with wealthy parents, their income would have probably precluded that anyway. Remember also that children (in Texas) under age 18 cannot conduct their own business, and those over 21 must conduct their own business. This often requires a custodial account, over which the parent maintains control. But that money becomes the child’s at age 21, and that can present some complicated freedoms as you might imagine.
There are also tax-free 529 college plans that don’t exclude anyone…yet. The use of 529′s is also restricted to education, and the parent maintains control no matter the age of the child. Much of this applies to grandparents as well.
Everyone’s situation is different, and all should seek counsel from their CPA.