If I Hire My Kids, Can I Give Them Tax-Free Education Beneﬁts?
Yes! Potentially, in two different ways. Here’s how.
Payments for Job-Related Education
Your business can reimburse an employee for certain education expenses, and the reimbursements will be treated as tax-favored working condition fringe beneﬁt payments.
- For the employee, that means the reimbursements are free of any federal income tax hit or federal employment tax hit. Nice!
- For your business, that means the reimbursements are deductible as employee compensation
expenses. Also nice!
This favorable federal tax treatment is generally allowed if
- The education is required by your business, or by law or regulation, for the employee to retain his or her current job; or
- The education maintains or improves skills required in the employee’s current job.
More Good News: When the preceding tests are passed, this favorable tax treatment is available for any employee, including one who happens to be related to the employer’s owner, such as your 22-year-old employee-child.
Favorable working condition fringe beneﬁt tax treatment is also available when your business pays for education that passes the preceding tests by making direct payments to the educational institution on behalf of the employee.
If your business pays for education that does not pass the preceding tests—such as education that prepares the employee for a new business or profession—the payments count as taxable wage compensation for the employee (unless the payments are run through a Section 127 educational beneﬁts plan, as explained later). In either case, your business can deduct the costs as employee compensation expenses.
Undergraduate Degree Program Cannot Be Work-Related Education
The IRS says an undergraduate degree automatically trains you for a new profession or business.
Therefore, reimbursements or payments by your business for costs for an employee, including your employee-child, to obtain a Bachelor of Arts or a Bachelor of Science cannot qualify as tax-free working condition fringe beneﬁt payments.
Presumably the same is true for costs to obtain a community college associate degree.
Sadly, the Tax Court has repeatedly agreed with the IRS on this issue.
So, if your business pays for an employee to obtain an undergraduate degree, the payments will represent taxable compensation for the employee. But your business can deduct the costs as employee compensation expenses.
Key Point: As stated above, the general rule is that employer reimbursements for or payments of undergraduate degree program costs won’t qualify for tax-free working condition fringe beneﬁt treatment. But the IRS informally says that each course in a program must be evaluated separately to see if an employer’s coverage of the cost of that course can qualify as a tax-free working condition beneﬁt.
For instance, if your employee-child’s work involves accounting, your business could apparently treat reimbursements for his or her undergraduate accounting courses as tax-free working condition fringe beneﬁt payments, even though those courses are part of an undergraduate degree program.
MBA Program Can Be Work-Related Education
The IRS has also taken the position that a Master of Business Administration (MBA) trains you for a new profession or business.
So, according to the feds, employer payments to cover the costs of obtaining an MBA cannot qualify as tax-free working condition fringe beneﬁt payments.
Thankfully, several Tax Court decisions say tax-free working condition fringe beneﬁt treatment should apply when the MBA program maintains or improves skills used in the employee’s current profession or business. If the MBA also happens to enhance the employee’s resume and increase his or her earning potential, that’s not a problem according to the Tax Court.
For instance, if your employee-child’s work involves management and administrative matters, your business can apparently treat payments to cover his or her MBA program costs as tax-free working condition fringe beneﬁt payments.
Payments under a Section 127 Educational Assistance Plan
Here’s another option. Your business can install an educational assistance plan that can give each eligible employee up to $5,250 in annual federal-income-tax-free and federal-payroll-tax-free beneﬁts. These tax-favored plans are called Section 127 plans, after the section of our beloved Internal Revenue Code that allows them.
Section 127 Plan Basics
Section 127 plans can cover the cost of just about anything that constitutes education, including graduate coursework, whether the education is job-related or not.
But some businesses set up Section 127 plans to cover only education that’s job-related. That’s up to your business to decide.
Your business can deduct payments made under the Section 127 plan.
To qualify for this favorable tax treatment, the education must be only for the participating employee—not for the employee’s spouse or dependents.
Also, the plan cannot cover courses involving sports, games, or hobbies.
If the employee is a related party, such as a child of the owner, some additional restrictions apply. We will explain.
Payments for Student Loans
Through the end of 2025, a Section 127 plan can also make tax-free payments to cover principal and interest on any qualiﬁed education loan taken out by a participating employee. The payments are subject to the $5,250 annual limit when combined with any other payments in that year to cover the employee’s eligible education expenses.
Loophole for Payments to Beneﬁt Your Employee-Child
You might think the Section 127 plan rules will mean no dice for employees who happen to be children of business owners. Not necessarily true. There’s a loophole for any employee-child who is
- Age 21 or older, and a legitimate employee of the business; and
- Not a dependent of the business owner (that would be you); and
- Not a more than 5 percent owner of the business.
Age-21 or older status is pretty likely when the employee-child spends substantial time working in the parent’s business and attends school only part-time.
Also, when the employee-child is working in the business and also attending graduate schedule, the child likely has age-21-or-older status.
Working in the parent’s business means the employee-child has an income, making it more likely he or she will not be a dependent under the federal income tax rules. Under those rules, a child is a dependent only if the child does not provide over half of his or her own support.
Bottom Line: What starts off looking like a narrow loophole ends up being wide enough to drive a truck through for many small business owners. Good!
Here are some more rules regarding your Section 127 plan.
- It must be a written plan for the exclusive beneﬁt of employees of your business.
- It must beneﬁt employees who qualify under a classiﬁcation scheme set up by your business that does not discriminate in favor of highly compensated employees or employees who are dependents of highly compensated employees.
Key Point: There is no discrimination problem if all your employees are eligible for the Section 127 plan, even though they all happen to be members of your family. But if you have other employees, you may have to cover them too.
- Your Section 127 plan cannot offer employees the choice between tax-free educational assistance and other taxable compensation such as wages. That means the plan beneﬁts cannot be included as an option in, say, a cafeteria beneﬁt program.
- It does not have to be prefunded. Your business can pay or reimburse qualifying expenses as they are incurred by the employee, including an employee who is your age-21 or older child.
- It must give employees reasonable notiﬁcation about the availability of the plan and its terms.
- It cannot funnel over 5 percent of the annual beneﬁts to more than 5 percent owners or their spouses or dependents.
Dodging the Bullet of 5 Percent Ownership
To avoid disqualiﬁcation of your employee-child under the rule stated in item 6, he or she cannot be a more than 5 percent owner of your business. Here we are talking about
- Actual ownership, such as via shares of stock in your C or S Corporation (or your partnership business) that the child directly owns in his or her own right, plus
- Attributed (indirect) ownership in the business under the attribution rules summarized below.
Stock Ownership Attribution Rules
Ownership in your C or S corporation is attributed to your employee-child if he or she8
- Owns options to acquire more than 5 percent of the stock in your corporation,
- Is a more than 5 percent partner in a partnership that owns stock in your corporation, or
- Is a more than 5 percent shareholder in another corporation that owns stock in your corporation.
Also, an under-age-21 child is considered to own any stock owned directly or indirectly by a parent (that would be you). But there is no attribution if the child is age 21 or older.
Bottom Line: Unless your over-age-21, non-dependent employee-child directly owns more than 5 percent of the stock in your C or S corporation, he or she should dodge the bullet of 5 percent ownership.
If so, your C or S corporation can set up a Section 127 plan and can start paying for and deducting your employee-child’s eligible expenses right now. Your employee-child will owe zero federal income tax and zero federal employment tax on up to $5,250 per year collected from the Section 127 plan. Nice!
Ownership Attribution for an Unincorporated Business
Your business may be unincorporated. That means you operate it as a sole proprietorship, a single-member (one-owner) LLC treated as a sole proprietorship for tax purposes, a multi-member (several owners) LLC treated as a partnership for tax purposes or a partnership.
In that case, you still have to worry about ownership being attributed to your employee-child. The good news is, the rules are the same as the rules for corporations that we just explained.
Bottom Line: Things should work out okay as long as your employee-child does not have direct ownership of more than 5 percent of your unincorporated business.
Payments for Job-Related Education: Your business can reimburse an employee for certain education expenses, which are tax-free for the employee and deductible by your business.
Undergraduate Degree Program Cannot be Work-Related Education: Generally, reimbursements or payments for an undergraduate degree don’t qualify as tax-free working condition fringe beneﬁt payments.
MBA Program can be Work-Related Education: Payments to cover the costs of obtaining an MBA can qualify as tax-free working condition fringe beneﬁt payments if the MBA program maintains or improves skills used in the employee’s current profession or business.
Payments Under a Section 127 Educational Assistance Plan: Your business can establish an educational assistance plan that provides each eligible employee with up to $5,250 in annual tax-free beneﬁts.
Loophole for Payments to Beneﬁt your Employee-Child: If your employee-child is age 21 or older, not a dependent, and not a more than 5 percent owner of the business, you can include him or her in a Section 127 plan for tax-free educational assistance.
More Rules: The Section 127 plan must adhere to several guidelines, such as being a written plan for the exclusive beneﬁt of employees, not discriminating in favor of highly compensated employees, and not offering employees the choice between tax-free educational assistance and other taxable compensation.
Ownership Attribution: If your employee-child is age 21 or older, he or she is not subject to the Section 127 ownership attribution rules.
Hiring your kids can be an effective tax-saving measure that also gives them excellent work experience. Additionally, you can assist them in paying for their education without owing any additional taxes thanks to tax-free education benefits. However, deciphering the complicated tax regulations can be challenging, and errors can be expensive.
At Morris + D’Angelo, we are passionate about empowering our Customers to make the most of their financial assets through smart tax optimization strategies. If you have questions or concerns about tax-free education benefits, our expert team is here to help.
Don’t let complex tax laws hold you back – contact us at Morris + D’Angelo to learn how we can support your financial success! This is our Expertise!
Parts of this article are published with permission from Bradford Tax Institute, © 2021 Daniel Morris, Morris + D’Angelo
Daniel frequently provides Media Content via Workshops, Podcasts, and Printed Articles on topics like Bitcoin and Cryptocurrency, Wealth Preservation and Planning, Global Banking, and many other high-level financial topics that serve and demonstrate the Value of our Global Network that should be of interest to those who need Private High-Wealth Services.
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