Summary:
IRS acceptable rules for shifting taxable income to children's lower tax bracket for saving taxes.

Save taxes by shifting income to children in a lower bracket. But learn the rules before you shift.

You can't transfer just income. The asset producing the income must be given to the child; income after the transfer is taxable to the child.

No tax return is required if a child's total income at any age is $750 or less.

Investment income for younger than 14: Special rules apply to investment income of children. To get an idea of how this works, assume generous parents give their dependent child investments that earn $1600.

Investment strategy: For children under 14, a common strategy is to purchase U. S. Series EE savings bonds for the child. If the child defers interest and tax until the bond is redeemed, and if the child is 14 or older when it's cashed, the interest will be taxed at the child's rate.

But you could use a different strategy if your child's investment income isn't expected to exceed $1,500 annually. The child may elect to recognize the income annually, as interest accrues, rather than waiting until the bond matures. This allows an under-14 child to eliminate or reduce the tax substantially, rather than defer it. Thus, when the child redeems the bond, no tax will be due on prior years' interest.

Over 13 or working: Investment income for children over 13 and income the child earns at any age is taxed at the child's rate. Earned income comes from personal services--like babysitting, delivering newspapers or working for a parent's business. If your child works for your business, it gets a deduction, and your child reports income in her lower bracket. Wages must be reasonable, however, as illustrated in these two cases:

• Walt and Dorothy Eller of Soquel, Calif., had three industrious children: Michael, 12, Patti, 11, and John, 7. The Ellers sold mobile homes and operated mobile home parks. Their children maintained swimming pools and grounds, read gas and electric meters, delivered leaflets and messages to tenants, cleaned trailer pads and did janitorial work.
  

Over three years the Ellers deducted $17,697 for payments to the children for these services. The court let most of the compensation stand except for the youngest child's. It reduced deductions by $1,000 because the court didn't believe a 7-year-old could do as much work as his older brother and sister.

• The Ellers fared better than Dr. David McKinney of Detroit, who deducted $11,000 paid to his children, younger than 12, for their work sorting mail, collecting trash and answering telephones. The court disallowed McKinney's deduction and assessed a fraud penalty. He deducted against his accountant's advice, the judge said, and buried it under a misleading label on his return.
  

(more at Planning, Other)