As you know, the federal income tax rates on qualified dividends and long-term capital gains are much lower than the tax rates on so-called ordinary income (such as salary, bonuses, self-employment income, short-term capital gains and interest income). The tax-rate differential provides a great tax-saving strategy that involves your family C corporation — assuming the “Kiddie Tax” doesn’t apply.
Example: Your 25-year-old daughter graduated from college last year. In 2017, you can give her up to $14,000 worth of stock in the family C corporation without any adverse federal gift or estate tax consequences. If you’re married, you and your spouse can together make annual joint gifts of stock worth up to $28,000. These gifts reduce your taxable estate in the best possible way — by removing appreciating assets from exposure to the tax collector.
Assuming your daughter is in the 10% or 15% rate brackets, she can receive dividends from the family C corporation and pay 0% federal tax.
This tax strategy works well with adult children, parents and others who are in the 10% and 15% rate brackets in 2017. Many individuals who make a perfectly good living are in these lower brackets (see right-hand box and the following examples). These people are eligible for the 0% rate on qualified dividends paid out by your family C corporation.
Two Scenarios to Illustrate the Tax Benefits:
1. Let’s say your son is married, with two dependent kids, and he files a joint tax return with his wife. Assuming he claims the standard deduction, his 2017 gross income for can be as high as $104,800 and he is still in the 15% bracket (up from $104,100 in 2016). In other words, if his total income, including qualified dividends, equals $104,800 or less, he will pay 0% tax on qualified dividends from your family C corporation. That’s because your son’s gross income is reduced enough by the allowable personal and dependency exemptions and the standard deduction amount in arriving at taxable income.
2. Let’s say your daughter is a single parent with two dependent kids. When filing her tax return, she claims the standard deduction and uses head of household filing status. Her 2017 gross income can be as much as $72,300 and she will still be in the 15% bracket. (If she is divorced, her gross income doesn’t include child support payments she receives from her ex-spouse). In other words, if your daughter’s total income, including qualified dividends, equals $72,300 or less, she will pay 0% tax on qualified dividends from your family C corporation.
The point: You don’t have to be poor to qualify for the 0% tax rate on qualified dividends from a family C corporation. A broad range of taxpayers can take advantage of this benefit.
Watch Out for the Kiddie Tax
If the Kiddie Tax applies to your child or grandchild, some of his or her investment income (including long-term capital gains and dividends from securities received as gifts) will be taxed at his or her parent’s marginal federal income tax rates — assuming those rates are higher.
Specifically, the parent’s marginal federal rate on ordinary income, such as interest and short-term capital gains, could be as high at a much higher rate than the child’s rate (the top rate is currently 39.6%). The child’s or grandchild’s rate on ordinary income is probably only 10% or 15%.
The parent’s marginal federal rate on long-term capital gains and dividends is probably 15% or 18.8% if the 3.8% Medicare surtax on investment income applies (this is also called the net investment income tax). The child’s or grandchild’s rate is probably 0%.
So avoiding the Kiddie Tax is a good idea, when possible. Fortunately, the Kiddie Tax applies only when all four of the following requirements are met:
Requirement 1: One or both of the child’s parents are alive as of December 31 of that year, and in a higher marginal federal income tax bracket than the child.
Requirement 2: The child doesn’t file a joint return.
Requirement 3: The child’s unearned income exceeds $2,100 for 2017 and he or she has positive taxable income after subtracting applicable deductions. If the threshold is not exceeded, the Kiddie Tax doesn’t apply. If the threshold is exceeded, only unearned income in excess of $2,100 is hit with the Kiddie Tax.
Requirement 4: The child must fall under one of the three age rules explained below. In all cases, it makes no difference whether or not the child is claimed as a dependent on someone else’s tax return.
The Age Rules
If the child is under age 18 on December 31, 2017, the Kiddie Tax applies if the other three requirements are also met for 2017.
If the child is age 18 on December 31, 2017, and he or she doesn’t have earned income that exceeds half of his or her support, the Kiddie Tax applies if the other three requirements are also met for the year. If the child or grandchild is a student, support does not include amounts received as scholarships.
If the child is age 19 through 23 at year end and meets both of these requirements: He or she is a student and doesn’t have earned income that exceeds half of his or her support, the Kiddie Tax applies if the other three requirements are also met for 2017. Your child or grandchild is considered a student if he or she attends school full-time for at least five months during 2017. Support does not include amounts received as scholarships.
Conclusion: This article explains how to take advantage of 0% federal income tax long-term capital gains and qualified dividends. However, consider the Kiddie Tax rules if your gift recipient will be younger than age 24 by the last day of the year. For those who will be 24 or older on that date, the Kiddie Tax rules do not apply, and they may be able to benefit from the 0% rate.