Tax-free College Tuition Reimbursements for Business Owner's Child-employee

by Dennis W. Donnelly, CPA, PFS

Dear clients and friends,

Section 127 educational assistance programs were set to expire at the end of 2012. Fortunately, the American Tax Relief Act of 2012 (a.k.a., the fiscal cliff legislation) made these taxpayer-friendly plans permanent. With the gut-wrenching cost of college these days, an educational assistance program can be a great way for small business owners to fund at least a part of the cost with tax-deductible (to the business) and tax-free (for the child-employee) dollars. But, of course, the right circumstance must apply for this to work.

Under an educational assistance program, the employer can provide up to $5,250 in annual tax-free educational assistance (for both undergraduate and graduate courses) to each eligible employee, and the employer can deduct the costs. To top it off, the education need not be job-related to qualify for this favorable tax treatment. In most cases, the assistance comes in the form of employer reimbursements for eligible expenses incurred by the employee. Eligible expenses include tuition, fees, books, tools, supplies, and equipment (but not room and board). Also, equipment, tools, and supplies (other than textbooks) aren't eligible if the employee gets to keep them at the end of the course.

Educational assistance benefits are generally thought to be unavailable in the context of small business owners who employ their college-age children and want to provide them with tax-free educational assistance. However, that is not entirely true. The child is eligible if he or she is-

1. age 21 or older,

2. a legitimate employee of the business,

3. not a more-than-5% owner, and

4. not a dependent of the parent (the business owner).

Observation: Because of the age-21-or-older consideration, many child-employees who meet the age requirement will be in graduate school. Of course, if they are still in undergraduate programs, that's okay too.

The Section 127 Educational Assistance Programs Qualification Rules

The qualification rules for tax-free educational assistance programs are as follows:

1. The program must be pursuant .to a separate written plan for the exclusive benefit of employees.

2. The program must benefit employees who qualify under a classification system that does not discriminate in favor of highly-compensated employees or their spouses and dependents. This rule will not be violated if all employees are eligible and all just happen to be members of the owner's family.

3. The program cannot offer a choice between educational assistance and other taxable forms of compensation. Also, educational assistance benefits cannot be included in a Section 125 cafeteria benefit.

4. Employees must be given reasonable notification of the availability and terms of the program.

5. Finally, and most importantly, the program cannot direct more than 5% of the benefits paid or incurred during the year to the class of individuals who are shareholders or owners, or spouses and dependents of shareholders or owners. For this purpose, however, only individuals who own more than 5% of the stock of a corporate employer or a more than 5% interest in capital or profits of an unincorporated employer (on any day during the year) are counted as shareholders or owners.

Note: As you can see, providing educational assistance benefits to an employee, who is the business owner's child, will not, in and of itself, violate Rule 5, as long as the child is not a more-than-5% owner and is not a dependent of the business owner. So far, so good.

Ownership Attribution Rules

At this point, the key issue is making sure the child-employee is not considered a more-than-5% owner. Otherwise, Rule 5 will almost certainly be violated if substantial educational assistance benefits are provided to the child-employee.

Corporate Employers. Ownership of stock in the employer corporation is determined in accordance with attribution rules which deal with parent-subsidiary and brother-sister controlled groups. This should not be a cause for concern in most small business situations.

In relevant part, it also attributes stock ownership to an individual if he or she owns options on stock of the employer corporation, is a 5% or more partner in a partnership owing stock in the employer corporation, or is a 5% or more shareholder in another corporation owning stock in the employer corporation. Again, in most cases, these attribution rules will not cause the owner's child to be considered a more-than-5% shareholder of the employer corporation.

Finally, an under-age-21 individual is considered to own any stock owned (directly or indirectly) by his or her parents. However, a child who turns age 21 is generally not attributed ownership of a parent's stock.

Bottom Line: As long as the child-employee is not a dependent and is age 21 or older, he or she can usually receive educational assistance benefits-provided he or she does not directly own more than 5% of the employer corporation's stock.

Unincorporated Employers. When the employer is an unincorporated business the attribution rules for unincorporated businesses will usually not cause an age-21-or-older child-employee to be considered a more-than-5% owner.

Bottom Line: Once again, as long as the child-employee is not a dependent and is age 21 or older, he or she can usually receive educational assistance benefits-provided he or she does not directly own more than a 5% interest in the employer.

Other Tax Breaks May Be Available Too

Collecting $5,250 in annual tax-free educational assistance benefits is a nice deal. Unfortunately, given the current cost of college (especially graduate school), it's often only a drop in the bucket. Never fear. Several other tax-saving benefits are likely available for expenses not reimbursed by the educational assistance plan.

1. For the first four years of the nondependent child-employee's post-secondary education, he or she may qualify for the American Opportunity Tax credit. However, the child-employee must carry at least half of a full course load in a degree program for at least one academic period that begins during each year the credit is claimed. The American Opportunity Tax credit is 100% of qualified tuition costs of up to $2,000 and 25% of the next $2,000, for a maximum credit of $2,500.

2. The nondependent child-employee is probably eligible for the Lifetime Learning tax credit. This credit is available for degree and non-degree programs (undergraduate and graduate) for an unlimited number of years. However, it isn't available if the child claims the American Opportunity Tax credit for the year. The Lifetime Learning credit is 20% of qualified tuition costs of up to $10,000, for a maximum credit of $2,000.

3. The nondependent child-employee may be eligible for the above-the-line deduction for up to $4,000 of annual college tuition (undergraduate or graduate). This write-off cannot be claimed in the same year as the American Opportunity Tax or Lifetime Learning credits.

4. The nondependent child-employee may be eligible for the college loan interest deduction (maximum $2,500 annually) for interest on loans used to pay excess college expenses (including graduate school costs). However, the loan must be used to pay expenses incurred only for academic periods during which the child-employee carries at least half of a full course load in a degree program.

Warning: The employee-child cannot claim any of the preceding tax goodies with respect to costs covered by payments from the Section 127 educational assistance program.

If the above conditions are met, there is significant tax assistance available to business owners employing their college-age children. Give us a call if you would like to explore this further.

Very truly yours,

Dennis W. Donnelly, CPA, PFS
Daniel A. Kosmatka, CPA, PFS, CFF, CGMA
Michael R. Gohde, CPA, PFS