Taxes: Putting Junior to Work

There's been much read and said over the years about how the US tax code discriminates against married couples and families. We've seen the "marriage tax," an increased tax bill applying to two-career families who file jointly (only partially remedied by the puny deduction passed a couple of years ago). And there's the problem of trying to raise children while paying taxes, since the $1,000 dependent exemption doesn't even begin to cover the actual costs of raising a kid. Not to mention the treatment of child support versus alimony, which encourages husbands to pay alimony (which is tax deductible) while discouraging payment of child support (not deductible).

However, the basic problem is this: when you have a graduated tax system, as we do, there is increasing pressure not to make money as you move up the income scale. A small disincentive to productivity and entrepreneurship at tax rates of 15 or 20 percent quickly becomes a big disincentive at 30 or 40 percent and more. This is called a "progressive" tax system by ignoramuses, many of whom control tax policy in America.

But this wacky system, which increases penalties on hard work, also encourages "spreading" income. That is, fixing your tax situation so that someone with a very low income receives taxable monies that a high-earner would otherwise have received. Why do this? To get away from those punitive higher tax rates.

Look at it this way: a single person earning a taxable income of $40,000 is going to be up in the 38 percent tax bracket, all other things being equal. Switch that now to two people earning $20,000, and the tax bracket for each will be down around 26 percent, quite a bit more manageable. Now divide that $40,000 into four incomes of a taxable $10,000 each, and we find four 16 percent tax brackets. Much nicer, no?

Then our only problem is finding someone to throw our money at. Look no longer: consider your children (or your closest friends, lovers, retired parents, gawky nephews, whoever). Unfortunately, income splitting won't work if you shift income to your spouse: the only two methods of filing for married people—joint filing or "married filing separately"—don't result in lower rates.

What if you have three small children? Do they normally pay for their own diapers and formula? Later, will they pay for their own clothing, babysitting and food? Still later their—gulp—own private school tuition? Not normally, you say? Such things come out of your hide, and they're not deductible? Well, how about making them deductible by shifting some of your income to the little buggers so that they can pay their own way for all the above? They don't have to have actual control over such funds if they're minors. You can still control the disposition of the money (after all, what kid wants to pay for milk, peas, and carrots instead of candy and cake?), but the ownership has to be effectively shifted to your child.

And that's where the tricky stuff comes in. There are three basic ways to shift income: you can give a gift of some income-producing asset; you can set up a trust; or you can hire the child to perform services in your business. This applies to any beneficiary you might choose other than your children, and each method can be used multiple times or in conjunction with each of the other methods.

The idea of a trust to shift income—easier to set up and use than you might think—is to grant income to someone whom you don't want to have ultimate control over the income-producing asset. This may be because the beneficiary is too young to handle the responsibilities involved, or because he might give new meaning to the saying "a fool and his money are soon parted," or maybe because you want that asset to eventually shift back to your ownership.

I'm not going to tell you anything else about trusts. A bit of knowledge is a dangerous thing. Go talk to your tax advisor about shifting income, and see a lawyer about drafting the necessary documents.

Then there are outright gifts. You own a small rental house and it brings in a few hundred dollars' a month income? Why not give that little building to your 10-year-old? Switch the deed over and everything. Then you act as manager for the property and make sure the money goes for food and clothing for the kid instead of Madonna posters and Quiet Riot albums. Only after the kid reaches age 21 (regardless of state rules as to age of emancipation) does the control over that asset have to shift. Then he can buy a Porsche and blow it all.

There's another tax-ruse that people often forget. If you own your own business, or at least have enough control that you can influence who gets hired, why not hire your own kids? Income can be shifted out of your pocket and into the child's. The trick is making sure the little rat spends it on stuff you would have had to pay for—medical care, clothing, food, tuition. The immediate result is that the child learns good lessons about work, thrift, responsibility, money, and suchlike. The net result is that everyone has less money stolen by the tax code.

Of course, any of the above tax dodges mandates careful planning, lest the IRS bureaucrats rip you off when they get the chance. Consult someone who knows what he's doing. Leave nothing to chance and you will certainly realize major tax savings. Who loses? Only the government. And who could deserve it more?

Tim Condon is an attorney and tax specialist practicing in Florida.