The DC should be aware that by paying some of what he would ordinarily take as income through his professional corporation to his son or daughter, he may be able to cause his tax rate to plummet.
Needless to say, the rules surrounding the income of a child of a professional are very confusing. The purpose of this article is to attempt to assist in clearing up some of that confusion.
The threshold concept is that if the DC's child is under age 14, he is now subject to the "kiddie tax." This means that on any "net unearned income" he receives in a particular tax year, he would be taxed at his parent's rate.
This restriction, however, applies to unearned income only and not earned income.
It becomes apparent that we must first define earned versus unearned income.
Unearned income is that which is earned by not working for it, such as interest generated on money in the bank or dividends paid from stock or rents from an apartment building, royalties from an oil well or even capital gains from real estate or stock.
Income earned by a child in the form of actually earned wages for services rendered is earned income and not subject to the kiddie tax.
With respect to the income being unearned, it matters not how the child receives the funds. It wouldn't make any difference whether it was a bequest as the result of a gift from a deceased relative or, as mentioned above, the net rents from an apartment complex.
The Internal Revenue Code describes net unearned income as the total unearned income less the combined total of $500 plus the greater of (1) $500 or (2) the expenses attributable to the unearned income. Thus, if the DC's child receives less than $1,000 or unearned income, it will not be taxed in the DC's bracket. $1,000 is the threshold.
Let us suppose that a child of the DC does have an amount of net unearned income. Is it reported on the DC's tax return? The answer would be in the negative because the child would need to file his own tax return, but the tax would be calculated as if the DC had earned the money (figuring the tax utilizing the DC's tax bracket).
What if the DC was in the process of obtaining a divorce? Would the husband's or the wife's tax rate be utilized to ascertain the amount of tax to be paid by the child on the unearned income?
Ordinarily, the child would pay taxes on the unearned income at the same tax rate as the parent who receives actual custody.
Of course, many of these problems concerning the kiddie tax do not exist once the child reaches his 14th birthday.