The effective rate of income tax imposed on certain individuals may reach 45 percent, or even higher, when the repeal of the Medicare wage-base cap, the limitation on itemized deductions, the phase-out of personal exemptions, and the liability for state and local taxes are taken into consideration. The tax rate for a child of 15, however, with only $10,000 of taxable income, is 15 percent.
If, in this situation, it were possible to shift $10,000 of income from the parent to child, immediate income tax savings of $3,000 (i.e., $4,500 – $1,500) could be achieved.
Assume the parent owns shares of GM, and receives quarterly dividend checks of $2,500. May the parent enter into a contractual arrangement with the child and assign to the child the right to collect those dividend checks? Yes, and that contract might be binding under New York law. However, that assignment of income would not effectively shift the federal income tax consequences of the dividend income to the child. This result is dictated by Horst, a Supreme Court case which stands for the proposition that the taxpayer who owns the income “tree” is taxed on all the income thrown off by that tree, which in our example is the GM stock. Gifts of “fruit” from the tree, which in our case was the right to receive dividends, are ineffective to shift the incidence of income taxation.
What if the parent actually gave the child 25 percent of his holdings in GM? In this case, since the gift was of a part of the “tree” itself, the child will be taxable on the dividend income produced by his shares of GM. This result accords with intuition. However, if the GM stock transferred were worth more than $10,000, (or $20,000 if the donor’s spouse agreed to split the gift) gift tax liability might be incurred on the transaction, although in most cases no gift taxes would be currently payable, owing to the $600,000 lifetime exemption from the transfer taxes to which every person is entitled.
Actually, by making this gift of GM stock, the parent has succeeded in accomplishing two important aspects of estate planning: First, as mentioned, the transfer enables the parent to utilize the $10,000 annual exclusion, and also permits use of a portion of the $600,000 lifetime exemption from transfer taxes.
Second, the gift removes future appreciation in the GM stock from the estate of the parent. Thus, if the stock were to double in price over the next 10 years, that appreciation would no longer constitute part of the parent’s taxable estate. This might be important if the total of lifetime and testamentary gifts, exclusive of the stock, were expected to exceed $600,000.
Suppose the parent wished to transfer the GM stock in trust, so that the child were not given outright control over the stock or dividend income? This could be accomplished without adverse tax consequences provided (1) the trust were irrevocable, and (2) the grantor (parent) did not retain prohibited “strings” over the trust, so that the gift were not deemed incomplete for income tax purposes. Code Sections 675 and 677 provide that where the grantor retains administrative powers (e.g., the power to purchase or exchange trust property for less than adequate consideration, or the power to borrow from the trust) or economic benefits (e.g., the right to have income distributed to the granter or his spouse, or the right to accumulate income for future distribution to the grantor or his spouse), the gift will be considered incomplete for income tax purposes, and the grantor will be taxed on the income of the trust.
Recall that the child in our example was 15 years of age. Suppose that his sister was 12 years old. Could the same tax treatment be obtained with respect to her? No, on account of the application of the “kiddie tax” provision in the Code. To prevent income shifting to children under 14, Congress imposes a tax on the child’s “net unearned income” in excess of $1,200, at the parents’ tax rate. “Net unearned income” includes interest and dividends, but does not include income which the child earns, for example, by acting or modeling.
Two other methods for shifting income to family members include the use of family partnerships and S corporations.
Since each partner in a partnership reports income based on his or her “distributive share” of the partnership’s income, it might be possible to create a partnership consisting of family members, and allocate income to members in lower tax brackets. Provided certain “safe harbor” rules are closely adhered to, this plan can achieve its purpose of redistributing income. In order to be considered “real” partners, family members must be the “true” owner of a “capital” interest. That interest must also be a “material income-producing factor in the partnership’s business activity.” A capital interest gives a partner a right to receive partnership assets upon liquidation of the partnership. Capital is a material income-producing factor if gross income of the partnership is, in substantial part, derived from the use of capital.
The I.R.S. will generally not litigate the issue of whether a family member is a true owner if that person’s interest was purchased at market price from another family member. If, however, the interest was gifted to the family member, and the donor retained effective control over the partnership interest, then the IRS may seek to tax the donor on that distributive share, irrespective of the transfer. The Treasury regulations list factors which weaken the contention of “true” ownership by a family member. They include the donor retaining excess control over (1) partnership assets, (2) partnership distributions or (3) partnership management; or (4) a limitation on the family member’s right to sell or liquidate his interest.
Family S corporations may also constitute an effective means of shifting income to other family members. For federal income tax purposes, S corporations are taxed similarly to partnerships. Profits and losses of the S corporation are “passed through” to S corporation shareholders, who then pay income tax on those passed-through earnings at their own individual income tax rates. As in the case of family partnerships, the IRS may challenge transfers of partnership interests to family members unless the stock is acquired in a bona fide transaction, and the family member is the “true owner” of the stock. Where the stock is purchased at market value, the family member is generally considered to be the true owner.