Shifting Income From Parents to a Child’s Lower Tax Bracket

Income shifting is a tax planning strategy that moves income from individuals in high federal income tax brackets to family members, like children, who are in lower brackets. The goal is to have the income taxed at the child’s lower rate, reducing the family’s overall tax liability. This strategy takes advantage of the progressive U.S. tax system, where higher income is taxed at higher rates. A child with little to no other income falls into the lowest tax brackets, so income that would be heavily taxed for a parent is taxed at a much lower rate when recognized by the child.

Understanding the Kiddie Tax Limitation

A regulation governing income shifting to children is the “Kiddie Tax,” which limits the ability of parents to move substantial investment income to their children to benefit from lower tax rates. The rules apply to a child’s unearned income, such as interest, dividends, and capital gains. It does not apply to earned income, like wages from a job.

The Kiddie Tax applies to children under age 19 and full-time students under age 24 who do not provide more than half of their own financial support. For the 2024 tax year, the first $1,300 of a child’s unearned income is not taxed. The next $1,300 is taxed at the child’s own income tax rate. Any unearned income above the $2,600 threshold is then taxed at the parents’ highest marginal tax rate.

For example, if a child has $5,000 of dividend income in 2024, the first $1,300 is tax-free, the next $1,300 is taxed at the child’s rate, and the remaining $2,400 is taxed at the parents’ rate. For 2025, the thresholds increase: the first $1,350 is tax-free, the next $1,350 is taxed at the child’s rate, and amounts over $2,700 are taxed at the parents’ rate.

This calculation is handled by filing Form 8615 with the child’s tax return. In some circumstances, parents may elect to report the child’s unearned income on their own return using Form 8814, though this can result in a higher overall tax.

Employing Your Child in a Family Business

Employing your child in a family-owned business generates earned income, which is not subject to the Kiddie Tax. For 2024, a dependent’s standard deduction allows them to earn up to $14,600 from a job and owe no federal income tax. The specific standard deduction for a dependent is the greater of $1,300 or their total earned income plus $450, up to the $14,600 limit for a single filer.

For this arrangement to be valid, the employment must be legitimate. The child must perform genuine services for the business that are appropriate for their age and skills. For instance, a younger child could perform basic tasks like cleaning or shredding documents, while a teenager might handle social media or customer filing.

The compensation paid to the child must be reasonable, meaning the wage is consistent with what the business would pay a non-family member for the same tasks. Paying a child an unreasonable wage, such as $50 per hour for simple filing, could be challenged by the IRS. Document the arrangement with a job description, timesheets, and regular payroll payments.

An advantage of this strategy comes from payroll tax exemptions for FICA (Social Security and Medicare) and FUTA (federal unemployment) taxes. If the business is a sole proprietorship or a partnership of only the parents, wages paid to their child under 18 are exempt from FICA taxes. Wages paid to a child under 21 are exempt from FUTA taxes.

These payroll tax exemptions do not apply if the business is a C Corporation or an S Corporation. In a corporate structure, the child is an employee of the corporation, and their wages are subject to FICA and FUTA withholding. The business should issue the child a Form W-2 to document the earned income.

Gifting Income-Producing Assets

Another method for shifting income is gifting assets that generate unearned income, like stocks, bonds, or mutual funds. This strategy uses the annual gift tax exclusion, which allows individuals to give a certain amount of assets each year without filing a gift tax return (Form 709). For 2024, this amount is $18,000 per donor, per recipient, increasing to $19,000 for 2025. A married couple can combine their exclusions to gift up to $36,000 in 2024 or $38,000 in 2025.

A common vehicle for holding gifted assets for a minor is a custodial account under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). These accounts are in the child’s name, with an adult custodian managing the funds until the child reaches the age of majority (18 or 21, depending on the state). Any gift made to these accounts is irrevocable, and the assets legally belong to the child.

The two account types differ in the assets they can hold. UGMA accounts are restricted to financial assets like cash, stocks, and insurance policies. UTMA accounts are broader and can hold any type of property, including real estate, making them a more flexible option.

When selecting investments for these accounts, it can be strategic to choose assets with long-term growth potential or those that generate tax-favored income like qualified dividends. Remember that any income generated within a UGMA or UTMA account is unearned income for the child and is therefore subject to the Kiddie Tax rules.

Utilizing Trusts to Shift Income

For more control over gifted assets, a trust is a formal alternative to custodial accounts. The advantage of a trust is that the grantor (the person creating it) can set specific rules for when the child can access the assets. This differs from UGMA and UTMA accounts, where the child gains unrestricted control upon reaching the age of majority.

One option is the Section 2503(c) trust, or Minor’s Trust, an irrevocable trust for a single minor beneficiary. To qualify for the annual gift tax exclusion, the trust’s funds must be usable for the child’s benefit before they turn 21. Any remaining assets must be available for withdrawal by the child at age 21.

A more flexible option is a Crummey trust, which gives the beneficiary a temporary right (often 30-60 days) to withdraw any contribution. This “Crummey power” classifies the contribution as a “present interest” gift, allowing it to qualify for the annual gift tax exclusion. The benefit of a Crummey trust is that the grantor can set distribution terms that extend well beyond the child’s 21st birthday.

Both trust types require an attorney to draft and establish correctly and involve administrative duties, like potentially filing a separate income tax return for the trust (Form 1041). Any income distributed from the trust to the child is considered unearned income and is subject to the Kiddie Tax. The primary function of these trusts is to provide a controlled environment for transferring assets while using the annual gift tax exclusion.