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Using IRC section 127 plans in a family business: employer-provided educational assistance.

With the passage of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (HR 4853), tax rates will remain at current levels and significant tax breaks will continue through 2012. One tax benefit that the act extended that's not so well known--but very important--is IRC section 127, which provides for the payment of up to $5,250 of qualified education expenses for every eligible employee.

Three types of educational assistance that employers may offer their employees, found in three distinct sections of the IRC, ensure employer participation in their employees' educations. The first is IRC section 132, which covers education provided under the working condition fringe benefit rules. These types of payments are deductible only if they are related to the employers' business. Education under the working condition fringe benefit rules must be required by the employer or by law for the employee to keep his present salary, status, or job. The required education must 1) serve a bona fide business purpose of the employer, or 2) maintain or improve skills needed on the job.

There are no dollar limitations on this type of educational assistance, and the employer may discriminate in favor of highly compensated employees. Even if the education meets one or both of the above tests, it is not considered qualifying education if it--

* is needed to meet the minimum educational requirements of the employee's present trade or business, or

* is part of a program of study that will qualify the employee for a new trade or business.

The second method that employers can use to benefit employees is a scholarship plan under IRC section 117. Scholarship programs, which are very structured and complex, provide the least amount of flexibility to the employer in terms of employer goals and objectives in benefiting family members along with other employees.

The third form of assistance is education provided to employees under a qualified educational assistance plan. These are educational expenses that are not job-related and thus not deductible for the employer as a working condition fringe benefit. Instead, they are paid as qualified educational assistance through an IRC section 127 plan and are deductible up to the $5,250 limit per employee per year. These plans have nondiscrimination requirements and other limitations; however, there are no restrictions on the type of education that can be paid for except the prohibition against education that involves sports, games, or hobbies--unless that education is part of a degree program. Expenses that exceed the $5,250 limit under IRC section 127 may be reimbursed under the IRC section 132 rules. If they do not meet the qualification requirements under the IRC section 132 working condition fringe benefit rules, they would be considered nondeductible educational expenses for the employer and taxable income to the employee.

Benefits under IRC section 117 and IRC section 132--and the myriad rules that govern them--are outside the scope of this article and will not be addressed in further detail


Qualified Educational Assistance Plans

As used in IRC section 127, the term "educational assistance" includes any form of instruction or training that improves or develops the capabilities of an individual. Education paid for or provided under a qualified program may be furnished directly by the employer--either alone or in conjunction with other employers--or through a third party, such as an educational institution. Education is not limited to courses that are job-related or part of a degree program. Education expenses include tuition, fees, books, supplies, and equipment; however, they do not include the cost of any equipment or supplies that the employee can retain after the course is completed, nor do they include the cost of meals, lodging, or transportation. The courses taken need not be job-related to qualify for exclusion, but the employer may restrict the program to job-related courses as long as that restriction does not discriminate, in form or practice, in favor of those employees for whom discrimination is prohibited.

Under IRC section 127, the employer can deduct these educational costs, and the payment is not subject to payroll tax (Federal Insurance Contributions Act [FICA], Federal Unemployment Tax Act [FUTA], or State Unemployment Tax Act [SUTA]) or workers' compensation premiums.

The Opportunity for Small-Business Owners

Typically, larger employers who want to incentivize their workforce to improve skills and productivity provide IRC section 127 benefits. But small-business owners can also use this benefit to pay the tuition expenses of their employees or adult children when the right set of circumstances prevails. It is important to note that this employer benefit can cover undergraduate and graduate or professional education expenses. The Exhibit details additional features and benefits of an IRC section 127 plan.

IRC section 127 establishes the following rules for family members participating in an employer plan:

* Participation is limited to employees. An employee may be an officer; a shareholder; a highly compensated employee; or a family member, spouse, dependent, or cousin who is an employee. The relationship doesn't matter in terms of initial participation. All that matters for step one is that an individual work for the company.

* The limitations on benefits begin with nonemployees. No one who is not an actual employee of the company may receive benefits.

* An employee who is the spouse or dependent of a greater than 5% shareholder or owner can only receive 5% of the total paid out to all plan participants during the plan year. For example, if $10,000 was paid out to nonowner, nonspouse, or non-dependent plan participants during the plan year, then an owner, spouse, or dependent who is an employee and plan participant may receive up to $500 of tuition benefits from the plan in that plan year.

The plan must benefit the employer's employees generally. Among those employees who can benefit from the plan are officers, shareholders, highly compensated employees, and the spouses or children of owners or highly compensated employees who are employees of the same company. The plan will not be held to be discriminatory if usage rates for the limitation class employees are higher than other employees generally. The key is that the requirements relating to eligibility for benefits must include all employees generally and not discriminate in favor of that ownership/highly compensated class.

There is an opportunity within these rules and parameters for business owners to use the IRC section 127 plan and provide the full $5,250 benefit to their child. In order to take advantage of this opportunity the child of the business owner must be--

* 21 years of age or older;

* a legitimate employee of the parents' business;

* not a more than 5% owner in her own right; and

* not a dependent of the parent/business owner, which signifies that she is providing over half of her own support. With a little planning, this should not be a problem for college students working part time for their parents' business.

One question that is often raised is, "Won't most children be finished or almost finished with college by the time they are 21?" That is hard to say. Many students are now taking five years or longer to complete their undergraduate studies, then another two or three years to complete graduate studies. In addition, students more frequently take a "gap year" off between high school and college, during which they work, volunteer, or travel. This timeline is even more likely if the student works a substantial number of hours in his parents' business. This working status makes it much more likely that the student is not a dependent.

The qualification rules for tax-free educational assistance under IRC section 127 are as follows:

* The educational assistance program must be a separate written plan of the employer for the exclusive benefit of employees.

* The program can benefit employees who qualify under a classification set up by the employer and found by the Secretary of Labor not to be discriminatory in favor of employees who are highly compensated.

* The program must not provide eligible employees with a choice between educational assistance and other compensation included in gross income.

* The program does not need to be funded

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

* The program cannot provide more than 5% of the total plan benefits paid in any plan year to the class of individuals who are shareholders or owners, or their spouses or dependents.

Worthwhile Benefits

Small-business owners can pay for their child's, grandchild's, or other family relation's college expenses with pretax dollars. What does this mean in practical terms? Suppose that an individual is in a 35% combined federal and state tax bracket. In order to pay $5,250 of tuition expenses for his child, he would have to earn and pay taxes on $8,076. With an IRC section 127 plan, the taxpayer pays that $5,250 tuition bill through his business and deducts it as an employer educational assistance plan benefit payment. Now, that $5,250 tuition bill costs him $3,412.50 after tax--a $4,663.50 savings per year of college with just a little advance planning.

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act granted a two-year extension for this treatment under IRC section 127; however, planners should note that IRC section 127 was originally written into the code in 1978 and has been extended eight times with overwhelming bipartisan support. Employer support for education is always popular and should remain so as budget constraints put downward pressure on other federal educational grants and loan support programs. Using this exemption to incentivize employers is tax policy at its best. These plans leverage private capital to support individual and corporate goals without' any direct or administrative role for the government.
EXHIBIT IRC Section 137 Features and Benefits

Written plan required                             yes

Must be candidate for a degree                    No

Undergraduate courses covered                     Yes

Graduate courses covered                          Yes

Pay for primary and secondary education           No

Benefits can be tied to years/hours
of service or past/future service                 Yes

Benefit paid in current year only                 No

Benefits can be prefunded on tax-preferred basis  No

Benefits can be accrued/awarded                   Yes
prior to actual tuition expense incurred

Must be job-related                               No
Courses qualifying employee for
new trade or business covered

Courses needed to meet minimum                    Yes
job requirements covered

Can discriminate in favor of                      No
highly compensated employees

Dollar limitation                                 $5,250

Expiration date                                   December 31, 2012

Employees include:

Current employees                                 Yes

Nonemployee family members                        No

Any family member or relative who is an employee  Yes *

Laid-off employees                                Yes

Retired or disabled employees                     Yes

Former employees                                  Yes

Independent contractors                           No

Educational expenses covered:

Tuition, fees, books, supplies, and equipment     Yes [dagger]

Education involving sports, games, or hobbies     NO [double dagger]

Meals/lodging, or transportation                  No

* May be limited based on ownership status or highly compensated status
[dagger] Supplied if required of all members of the class and used up
during term. Provided if employee will not retain ownership after course
[double dagger] Can be paid if part of a degree program

By Jim Northam and Gary E. Carpenter

Jim Northam is president and founder of College Bound Inc., Lakeville, Minn. Gary E. Carpenter, CPA, is cofounder and executive director of the National College Advocacy Group, Syracuse, N.Y.

For an in-depth discussion of the rules and regulations that apply to the three different code sections mentioned in this article, text GCBI to 69302 and ask for a copy of the College Bound Inc. white paper, "Providing Educational Assistance Through the Family Business" or e-mail Jim Northam ( or Gary Carpenter (
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Title Annotation:personal financial planning
Author:Northam, Jim; Carpenter, Gary E.
Publication:The CPA Journal
Date:Nov 1, 2011
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