Tax Savings With Employer-Financed College Costs
When an employer sets up and administers a qualified Section 127 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, fully deductible by the employer.
Eligibility
Children of parent business owners can get benefits
Despite the IRS’s normally strict rules against discrimination, the eligibility rules below allow a Congressional-mandated “loophole” for children of business owners. The rules are as follows:
A) the employee must be age 21 or older,
B) he or she must be a legitimate employee of the business,
C) must not own more than 5% of the business, and
D) not be a dependent of the parent business owner.
Important Note: A child of a parent business owner may receive up to the $5,250 educational assistance limit if the child is age 21, not a dependent probably by virtue of having a full time job, and doing actual work in the business. Section 127 does not specify whether the employment needs to be fulltime. Presumably that is what is meant by being legitimate. Most children age 21 or over will either just be graduating or in graduate school and will be eligible. If the child uses the money for graduate school, that leaves more of his or her own money to pay off undergraduate school loans. Also, if a grandparent is the owner of the business in which the grandchild works, the grandchild can still be a dependent of his or her parents.
Qualification Rules
There is a certain formality
1) There must be a written plan in conformity with IRS rules and it must be for the exclusive benefit of employees.
2) The plan must define which employees qualify for benefits, and it must not discriminate in favor of highly compensated employees or their spouses and dependents. It is OK if all eligible employees happen to be members of the owner’s family.
3) The plan cannot offer a choice between educational assistance and other fringe benefits or compensation. The plan cannot be part of a cafeteria plan.
4) There must be reasonable notification of the availability and terms of the plan.
5) In operation, the plan cannot direct more than 5% of the benefits paid or incurred during a particular year to a class of employees who are shareholders or owners, spouses, or their dependents. Only shareholders or owners who own more than 5% are considered shareholders or owners for purposes of this rule.
The Bottom Line
It’s great to pay for college with before-tax dollars.
As long as a child of an owner or shareholder is not a dependent and does not own more than 5% of the business, the child is an eligible employee for tax-free educational reimbursement benefits. Benefits cannot be paid to business owners who own more than 5% of the business. Otherwise, the plan will be disqualified and all payments will become taxable. Anyway that college expenses can be paid by pre-tax dollars is a winner.
Other Tax Breaks Are Still Available.
Using a Section 127 Educational Reimbursement Plan does not negate the use of the credits and deductions now available, such as the $1,500 HOPE Scholarship credit, the $2,000 Lifetime Learning credit, the $4,000 college tuition deduction (for 2008 only at this point) and the college loan interest deduction. These continue to be available, subject to phaseouts and eligibility.
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