When clients seek to offer financial support to family members, shifting money “upstream” or “downstream” can be an appealing and tax-efficient way to transfer assets.
Aid to aging parents is termed “upstream” gifting, says Ryan Halpern, a CPA and wealth advisor with Brightworth in Atlanta, while “downstream” transfers refer to plans involving younger generations — although the so-called kiddie tax can add an extra layer of complexity.
“For income shifting, client motivation usually results from a desire to make gifts to parents or adult children who are in much lower tax brackets,” says Sheila Padden, a CPA and planner who heads Padden Financial Planning in Chicago.
Up with tax advantages
Transfers to parents may involve gifts of dividend-paying stocks or stock funds. The payouts usually are qualified dividends, on which clients might owe 15% or 20% in tax. In the hands of taxpayers — including retirees — with 2020 taxable income up to $80,000 on a joint return ($40,000 for single filers), such income falls into a 0% tax rate. Ultimately, the clients who gave away the equities might inherit them in the future with a basis step-up, effectively removing any tax on all prior appreciation.
Another plan is to give appreciated securities to seniors, who can sell them for needed cash. Again, if taxable income is up to the amounts mentioned previously, there will 0% tax on profits treated as long-term capital gains. Helping clients’ parents with their financing can be vital, as many retirees live on tight budgets.
Down with tax payments
Whereas parents may have reduced income in retirement, clients’ children may be years away from their peak earnings years. To shift taxable income, dividend-paying equities might move to a younger generation in order to generate untaxed dividends, or clients might transfer appreciated securities that are planned for sale so that their children could cash in without paying tax on the gains.
The kiddie tax, which applies to dependents under age 19 and full-time students under 24, may affect downstream gifting. “To determine if a dependent child is subject to the kiddie tax, add up the child’s net earned income and net unearned income," says Halpern. “Then subtract the child’s standard deduction to arrive at taxable income. The portion of taxable income consisting of net earned income is taxed at regular rates while the portion of taxable income consisting of net unearned income over $2,200 this year is taxed at the parents’ marginal federal income tax rate.”
Thus, if clients have kids, tax planning would focus on keeping investment interest, dividends and capital gains below $2,200, where taxes will be low.
Once the kiddie tax no longer applies, more investment income can be taxed at lower rates. “Gifting highly appreciated shares to adult children who are not subject to the kiddie tax, while staying under the $15,000 annual gift tax exclusion limit, can be a good strategy if the children are in very low income tax brackets,” says Padden.
Assuming these assets have a long-term holding period carried over from the parents, the child could sell, possibly use the 0% tax rate, and use the proceeds for a down payment on a first home, Padden points out.
Downstream income shifting also can be part of a larger estate plan, reports Brooke Salvini, a CPA and financial advisor, who heads Salvini Financial Planning in Avila Beach, California, who recounts this example from her practice:
“A client has been gifting shares of an LLC that mainly holds farm land to younger relatives,” she says. “The LLC generates some income from leasing land for row crops so increasing the children's and grandchildren's ownership percentage, without giving them a controlling interest (which the clients have said they definitely don't want to do), spreads the income into lower tax brackets.”
Salvini says her role has been presenting the “big picture” to clients, guiding the parents through decision-making process. “We’ve discussed how much control and ownership they are comfortable transferring,” she says. “How much should they transfer to utilize the current $11 million-plus inflation lifetime gifting allowance, which is scheduled to revert to a $5 million-plus inflation amount at the end of 2025? These clients have an attorney in place and we use the appraiser who was previously hired.”
An alternative to gifting assets, Halpern notes, is for business-owner parents to hire their children. Earned income is not subject to the kiddie tax, so salaries that are deductible for a business can be reported by a son or daughter who will owe little tax.
“Since the standard deduction was nearly doubled in 2018, and now stands at $12,400 for single taxpayers, this has become an opportunity to pay children more money without facing a tax bill,” he says. When hiring family members, it’s vital to document that their compensation is reasonable for the work performed, and that the parent’s reported earnings also are reasonable.
COVID-19 wrinkle
“For advisors,” says Padden, “the most challenging aspect of income-shifting is the possible complexity for the recipient — opening an account and selling the securities. My flat-fee agreement includes the client and the client’s family, so if the recipient wants to open a retail account, I could help to make sure the transaction goes as planned.” Padden adds she would need a signed agreement to work with the recipients on an ongoing basis.
The complexities involved in explaining income shifting to clients has been heightened by the coronavirus pandemic. “Recent market volatility has put a halt to, or at least slowed, some of these tactics,” says Halpern, “as clients are feeling a bit more hesitant about transferring assets to their children or parents. Once markets settle down and the recovery is in sight, I believe these tactics will resume.”
Salvini says that her clients with the LLC had planned to give more shares to younger relatives, starting in February. “COVID-19 brought it to a halt. It makes sense to take care of this now — estate planning is always important but never more so than now, with the health crisis. The uncertainty of these times is making it hard for them to move forward but I’ll keep encouraging them to start the process.”
With some encouragement from advisors, clients can strengthen family ties and reduce the tax collector’s share of multigenerational income.
