Other Relevant Tax Information

Tax-exempt income

Generally, whenever individuals receive wealth they also have a Gross Income inclusion for tax purposes (see Exhibit 1 on page 9).  However, Congress long ago determined that certain forms of wealth increase would not be income for tax purposes.  Some of these tax-exempt receipts can be very significant and you need to be generally aware of the exempted categories of income.  Some of the more common categories for typical Americans are listed below.  Remember, it is the person who is the recipient of these payments that gets them income tax free under the Federal tax laws:

Life insurance proceeds but only if paid by reason of the death of the insured (we will discuss this category in greater detail under the Life Insurance Planning section of the book),
Lifetime gifts (the donor may be liable for gift tax on gifts over $11,000, but the donee receives them income-tax free),

At-death gifts-bequests and inheritance (the decedent's estate may be liable for estate taxes),

Health insurance benefits or employer reimbursements for health care,

A legal recovery of damages for physical (bodily) injury,

Scholarship grants applied toward tuition, fees, and books - but not room and board (we will analyze this category in detail under the Educational Savings section of the book),

Social Security benefits to a limited extent – if married taxpayers, with less than $32,000 of Adjusted Gross Income ($25,000 of AGI for single taxpayers),

The sale of your home (see page 50).

There are other categories of tax-exempt income as well that are less commonly encountered.  Study the Form 1040 Instructions (go to my Web site, click on Tax Planning and then Forms and Instructions, as well as Publication 17, Your Income Tax, Chapter 13 – Other Income).

Gifting highly appreciated stock or other property to children

In the Retirement Planning section of the book, I strongly advise you to not invest significantly in stock of a single company.  What I do advise you to do is invest in stock ownership of many companies through diversified stock mutual funds.

Let's say that despite my advice, you own through purchase or inheritance highly appreciated stock or other investment property (like land).  By highly appreciated, I mean that the fair market value of this property is significantly higher than its tax basis (your cost if you purchased it or its fair market value on the date of death of the decedent if you inherited the property).

If you sell this highly appreciated property, it will trigger a long-term capital gain to the extent of the difference between that fair market value and tax basis.  Long-term capital gains are taxed at favorable rates of taxation relative to ordinary income.  If your normal marginal rate of taxation (see Exhibit 2 on page 12) is 25% or greater on ordinary income, your maximum rate of taxation on long-term capital gains is 15%.  If your normal marginal rate of taxation on ordinary income is 10 or 15%, your maximum rate of taxation on long-term capital gains is only 5%.  This favorable rate of taxation on long-term capital gains relative to ordinary income is great and, by the way, provides a strong incentive to invest in our economy.

Apart from these general rules, where am I going here?  Your children may be in a significantly lower rate of taxation than you are.  Is there a way to shift wealth to the children to accommodate their needs and have the inherent income taxed at their lower rates?  Sometimes.

You cannot shift your wage income to anyone.  It is a long and hallowed tax rule that personal service income is taxed to the taxpayer who earned that income.  Capital gain income, however, is a different story.  We can shift that built-up income to another taxpayer by transferring legal ownership of the underlying property to the other taxpayer.  This form of tax planning is known as "income splitting" and it can be an extremely effective way of keeping wealth within the family unit while substantially lowering the overall tax hit.  You can study an Example of income splitting under the Educational Savings section of the book at page 115.

There are some significant hitches in this tax planning technique:

The child/new owner of the property must be age 14 or older in the year the property is sold.  Otherwise, the effective tax rate is usually the parents' not the child's;

The child is now the owner of the property and any after-tax cash proceeds once the property is sold.  In other words, for this technique to work there must be a true and effective gift of the underlying property from parent to child.  As long as the child is a minor, the parents can act as custodian over the child's wealth but must use the wealth as if it were the child's not the parents'.

If the child's wealth is used to satisfy a parental support obligation, income is taxed back to the parents.  Things like food, shelter, medical care and elementary and high school educational expenses are generally considered parental support obligations.  Non-necessary items like college expenses, a child's automobile, vacations, music, and acting lessons are generally not considered to be parental support obligations and may be satisfied out of the child's wealth without a taxable event to the parents.

Increasing your child's wealth may have a detrimental effect on obtaining financial aid for that child's college education (see page 115).

Obviously, if you are going to dabble in this area to a great extent, it would be sound wisdom to retain the services of a competent Certified Public Accountant in your area.  Look in your yellow pages or go to my Web site, click on Tax Planning, and then click on State Societies of CPAs.  Each State Societies of CPAs noted on my Web site has a referral service to assist you in retaining a competent CPA near where you live.

Also, a competent investment company and/or stockbroker will be needed to assist in the legal transfer of stock ownership to the child.  If the highly appreciated property is non-stock property, a lawyer should be retained to assist in the legal transfer of ownership of land or other property (see page 127 - Locating a Lawyer, and Obtaining The Services of a Professional Financial Advisor at page 96).

For a more detailed analysis of this tax planning technique, go to my Web site and click on Altieri Publications and study my article on Income Splitting that is listed along with my other professional publications.