Strategies fo Avoid the "Kiddie Tax"

Before 1986, parents shifted investments to children so that interest and dividend income from the investments would be reported on the children’s returns. Often, children paid little or no tax because they sheltered the investment income with their standard deduction and exemption deduction and paid tax at their low tax rates.
In 1986, Congress attacked this tax strategy in three ways. First, only one exemption deduction per person is allowed. If you claim your child as a dependent on your return, your child loses his or her personal exemption deduction.
Second, if you claim your child as a dependent on your return, your child’s standard deduction decreases to the greater of $950 or the compensation income of the child plus $300. Thus, if your child’s compensation income is $400, your child’s standard deduction is $950. If your child’s compensation income is $1,800 then your child’s standard deduction is $2,100. This increased standard deduction is one advantage of hiring your children to work for you.
Third, if your child is subject to the kiddie tax, your child’s investment income over $1,900 may be taxed at your tax rate. Dependent children with investment income greater than $1,900 may be subject to the kiddie tax if they are under the age of 19 or are full-time students ages 19 to 23 who do not earn more than one-half of their own support. You can use the chart at the end of this article to help determine if your child is subject to the kiddie tax.
Strategies available-
You can use several strategies to avoid paying tax on your child’s investment income at your tax rates. First, you do not even need to file a return for your child if your child’s income is under $950 unless he or she has net earnings from self-employment of $400 or more.
Second, your child who is potentially subject to the kiddie tax can receive $1,900 of investment income in addition to compensation income before paying tax at your rate. For 2011, your dependent child’s standard deduction is the greater of $950 or your child’s compensation income plus $300 up to $5,800.
If your child has $1,400 of investment income and no compensation income, then your child’s taxable income is $450 ($1,400 - 950). The income is taxed at your child’s tax rate.
If your child has $2,000 of investment income and $6,000 of compensation income, then your child’s taxable income is $2,200 ($2,000 + 6,000 - 5,800).
Of the $2,200, $100 ($2,000 - 1,900) is taxed at your tax rate and $2,100
($2,200 - 100) is taxed at your child’s 10% tax rate.
In other words, compensation income can increase your child’s standard deduction and it does not change the amount of investment income your child can receive before your tax rate applies to his or her income.
Third, when your child’s investment income reaches $1,900,
consider investments that do not increase your child’s taxable income. Examples include:
Tax-exempt municipal bonds,
Growth stocks which pay no current dividends,
Real property which appreciates in value, and
Tax-deferred U.S. Savings bonds.

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Post Updated May 2, 2015