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No sooner had Democrats taken charge of the tax-writing committee in the House of Representatives than they proved once again that their idea of who is “wealthy” in America is much broader than many people might expect. Specifically, the House recently passed legislation (H.R. 976) that would curb the tax effectiveness of so-called “custodial accounts” for taxpayers with annual income of more than $31,850. The origin of this change is more convoluted than most tax increases. When the Democratic majority in the House fulfilled its much-heralded promise to raise the federal minimum wage, the Senate and the White House insisted that such a measure include tax breaks for the small-business employers who would be most affected by this cost increase. Those tax breaks, however, had to be offset under the Democratic majority’s new pay-as-you-go rules. That is, the anticipated revenue loss attributable to the small-business tax breaks required tax increases in other areas of the law. And one of those areas was asset shifts by “wealthy” taxpayers. Here is how it works. Although most taxpayers pay tax on their long-term capital gains at a 15% rate, taxpayers whose income places them in either the 10% or the 15% tax bracket pay tax on their gains at only 5% this year and not at all starting next year. The bill just passed, however, would deny this lower tax rate on capital gains (and dividends) to any recipient who is a “dependent” under age 19, or who is under age 24 and attending college at least five months during the taxable year. This revenue-raiser purports to counter asset-shifting of appreciated stocks and other assets by the “wealthy,” but actually it will affect any parent whose income places him or her above the 15% tax bracket. For the current year, that means anyone whose taxable income exceeds $31,850 will lose the tax benefit of transferring property to a family member in a lower tax bracket. If this tax provision is retained in the minimum wage bill, which seems likely, families would be well advised to avoid placing capital assets in a student’s name. Such arrangements already receive the harshest possible treatment in the federal college financial aid formula, and now they would offer no compensating tax benefits. Parents and grandparents who want to save for their progeny’s college expenses should put their money instead into so-called 529 plans, because those plans are not affected by this change. For folks with existing custodial accounts, however, this tax legislation is one nasty surprise. Many of these accounts, in fact, were set up years ago and, in some cases, decades ago � long before 529 plans came into existence. After all, these plans did not become widely available until after the first Bush tax act. That legislation provided tax-free treatment of 529 plan withdrawals used to pay tuition, room and board, and related costs of higher education. And it was only this past August, in the Pension Protection Act of 2006, that the tax benefits of these plans were made permanent. Before that, the only tax-efficient way that middle-income parents and grandparents could save for their children’s and grandchildren’s college education was to establish custodial accounts. Notwithstanding the good intentions of these middle-income Americans, the ill-considered provision passed by the House does not grandfather any existing investments and in fact would be retroactive to the beginning of this year. The manifest unfairness of trashing people’s reasonable expectations hardly inspires confidence as the new majority in the House attempts to rescue the “middle class” from larger tax issues, including the increasing incidence of the alternative minimum tax. What this legislation demonstrates is that House Democrats apparently believe that anyone with an annual income of about $32,000 can properly be considered “wealthy.” Is this a great country or what? Richard L. Kaplan is the Peer and Sarah Pedersen Professor of Law at the University of Illinois College of Law and the author of Funding a Grandchild’s College Education, which can be accessed at http://papers.ssrn.com/sol3/papers.cfm?abstractid=285002.

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