Archive for College

Did You Know Employing Your Kids Means More College Savings Options? How Your Children can Use an IRA

You probably already know about, or have at least heard of, 529 plans as an investment option for paying for your child’s college education. But, did you know that if you employ your kids in your business, you actually have an option that other people don’t? Children who are employed by their parent’s company have the ability to use an IRA account to pay for college without penalties. That’s a huge advantage!

How It Works

Depending upon how much your children make working for your business, they may benefit more from either the Roth IRA or the traditional IRA—either one is available for their college savings.

Here are the primary reasons that it’s a good choice:

  • For qualified higher education expenses, such as tuition, books, fees, room and board, and even supplies, a child can withdraw the money penalty-free.[1] As long as the child only withdraws the amount needed for qualified expenses, the ten percent early-withdrawal tax does not apply.[2] Of course, for the traditional IRA, regular federal income taxes will apply. Keep in mind that for some costs, the student must be enrolled at least half time in order to qualify.
  • It’s possible that the IRA won’t be factored in when determining student and parent resources for financial aid decisions. The Free Application for Federal Student Aid (FAFSA) is the financial aid form used by most public higher education institutions. This form does not include a section asking about IRAs because it is not typically an asset that is considered available as an educational resource.[3] However, private institutions are more likely to consider the IRA an educational asset and factor that in.[4] If your student is able to exclude the IRA from FAFSA calculations the first year of college, be aware that any IRA distributions will be counted as income on the FAFSA the next year. That is, money in the child’s IRA is not calculated, but money taken out of the IRA is.[5]
  • The money grows tax deferred. Because this provides your child with a great head-start on compounding interest, you should start your child’s savings early and continue it until age 18. Child labor laws do not apply to children who work for their parent’s business (unless the business is particularly dangerous—check the guidelines if you’re unsure), so your child can start earning as early as they can provide a valuable service to your business. This could be as early as seven years old. Of course, this only works if the chosen investments provide a good return.
  • Here’s an example of 12-year growth for a child who contributes $5,000 annually. A 0 percent annual return gives them $60,000. A 2 percent return equals $68,402. But, a 15 percent return garners a total of $166,760 after 12 years.
  • The account could help to reduce or eliminate the kiddie tax imposed on children’s investment income. The kiddie tax imposes the parents’ tax rates on the child’s income. Let’s say your child earns $6,200 at your business for the year (that is the standard deduction for 2014), and they also received $5,000 in investment dividends ($11,200 total). They would have to pay taxes at your tax rate for the additional $5,000. But, if your child contributes their dividend income into a traditional IRA, then they are left with zero taxable income.
  • Even if the child’s income is too low to be taxable, they can use a Roth IRA to continue growing the money and deferring taxes. Usually taxes are paid up-front for the Roth, but in this case, there are no taxes to pay up-front! That means when your child withdraws money from their basis, they do not have to pay taxes when the money goes in nor when it’s withdrawn. If the child contributes $6,000 every year for 12 years, they’ll have $72,000, none of which they ever have to pay any taxes for (because the yearly contribution is less than the standard deduction)! Of course, any interest earned on that amount will be subject to taxation upon withdrawal. A traditional IRA, by contrast, does not have a tax-free basis because the contributions are tax-deductible.
  • If the child earns more than the standard deduction, they get double benefits. Your child will want to get the tax deduction from contributing to a traditional IRA if they earn more than the standard deduction in combined work income and investment income. This means they get the tax deduction, and the money then grows tax-deferred.

It really does pay to employ your children, and the advantage is certainly not all on your side. You can give them a helpful step towards a financially secure future, including making college more affordable and teaching them valuable lessons about how to grow their money. When choosing an IRA for your child, the Roth IRA is best for those earning less than the standard deduction. Otherwise, you’ll want to defer a larger sum of the taxes by choosing a traditional IRA and reducing (or eliminating) their tax bill.

  1. IRC Sections 72(t)(2)(E); 72(t)(7)(A); 529(e)(3).
  2. Notice 97-60, Section 4.
  3. “ASK THE BIZ BRAIN,” Business p. 007, The Star-Ledger (Newark, New Jersey), August 10, 2009
  4. “ASK THE BIZ BRAIN,” Business p. 005, The Star-Ledger (Newark, New Jersey), October 11, 2009.
  5. “Roth Can Be Expensive Gift for 16-Year-Old” by Gail MarksJarvis, (Business; Zone C; p. 5), Chicago Tribune, July 8, 2007.

Deducting Business Education? Here’s What You Need to Know

Depending upon the field you’re in, business education can be a significant expense. Do you have to keep up with certain certifications? Do you need to learn a particular skill? Are you seeking more knowledge about running a business in general and gaining customers?

Lori Singleton-Clark attained an online MBA in order to increase her business knowledge. In one year of the program, she spent $14,787 on her business education, and that is the deduction she claimed on her tax return. Guess what? Ms. Singleton-Clark fought the IRS and won her deduction in court.[1] Even more encouraging is the fact that she did not hire an attorney and was able to represent herself sufficiently by having the right documentation.[2]

Why We Have Business Education Deductions

The government wants to help out people who are in business. It’s beneficial to the economy for the government to help businesses succeed. Because the government acknowledges the vast amount of information necessary to run a company, they give you tax breaks in order to get that knowledge and use it for the advantage of your business. Depending upon your industry, this knowledge could come in any number of forms, such as:

  • Learning to play golf
  • Learning to fly a plane
  • Learning about software
  • Finding out more about marketing
  • Obtaining writing skills
  • Obtaining negotiating skills
  • Obtaining selling skills

Education does not just mean taking classes. You may obtain your education at seminars or conventions.[3] Or, you may even hire a private coach.[4] As long as this education meets the requisites for deductible business education, you can save money on this necessity. So, how do you qualify?

Qualifying for the Deduction

The basic rule for qualifying for the deduction is pretty simple. In order to deduct the expense, the education obtained must either improve the skills you need in your business or maintain your current business skills, and it cannot train you for a new business.[5] Let’s break that rule down into some more specific guidelines:

  1. You must already be in the business the education pertains to.[6]
  2. In the business does not mean simply working in the field. To qualify, you must already have the basic, entry-level education required for the business—you cannot deduct minimum-requirement training.[7] However, if regulations change after you’ve entered the business, your expenses qualify if you need to get up-to-date with new requirements.
  3. The determination that you need the education can come either from yourself, from an employer, or from a change in legislation regarding your industry.[8]

Here are some examples of education costs that do not qualify:

  • Courses taken in the pursuit of a bachelor’s degree
  • A nurse taking courses to become a medical doctor
  • A legal assistant obtaining a law degree

But, these do qualify:

  • A dentist taking additional coursework to become an orthodontist[9]
  • A teacher seeking a Master’s or Ph.D. in their field[10]
  • A psychiatrist obtaining psychoanalyst training[11]

These latter three situations qualify for the deduction because each person is maintaining their current job (they are still a dentist, teacher, and psychiatrist) but increasing their skills.

Case Examples

Patrick O’Donnell did not get his deduction for the cost of attending law school. O’Donnell was a CPA who worked with lawyers regarding taxes. Although he already worked with lawyers and continued in the same position after receiving his law degree, he was not eligible for the deduction because it qualified him to eventually switch careers and become a lawyer if he chose. That is, a law degree is the bare minimum requirement for being a lawyer; thus, it is entry-level education for a particular field.[12] Bachelor’s degrees and medical degrees work the same way.[13] You will not be able to deduct any of these degrees.

An MBA degree, on the other hand, often is deductible. That’s because the majority of people who pursue the degree are already in business. Therefore, the degree contributes to knowledge in an area they are already involved in. Robert Beatty, for example, earned an MBA in order to improve his administrative, management, and interpersonal skills. He worked in management as an engineer, and the skills he obtained directly improved his business.[14] Beatty did get his deduction.

However, you may want to know a few tips about proving you are in the business for which you are receiving and deducting an MBA:

  • It’s best if you’ve been in the business for a few years before beginning the MBA. Trying to get one after only a few months in a new business could be harder to justify to the IRS.
  • If it’s possible, pursue your degree part time rather than full time. This allows you to continue working in your business while you obtain the degree.
  • If you decide to go the full-time route, you’d better plan your time efficiently. Quitting your business and doing nothing for a year before beginning the degree program may mean no deduction.

Daniel Allemeier, Jr. is another example of someone who pursued the MBA and won his deduction.[15] He was a well-respected salesperson and trainer for a dental products company, and after being with the organization for three years, he chose to get an MBA. Shortly after enrolling in the degree program, Mr. Allemeier’s employer promoted him to marketing manager. The employer’s policy stated that it would not reimburse employees for education, so Allemeier chose to pay for his MBA himself while continuing to work full time. Although his employer did not require this education, the CEO of the company did encourage it in Allemeier’s case.

Do you see why Mr. Allemeier was able to defend his deduction?

  • He had been in the same business for several years;
  • His degree did not qualify him specifically for any other profession;
  • The MBA coursework improved the skills he currently used in his position; and
  • The MBA was not a requirement for his promotion, even if it may have helped in that regard.

In another court case, Deputy District Attorney Edward Kosmal defended his deduction for Spanish lessons. He won because he worked in a community with many Spanish speakers, and this education helped him to better perform his job.[16]

Kenneth Knudtson was even able to deduct the cost of flying lessons.[17] He successfully proved an ordinary and necessary business expense for both the cost of his plane and the lessons because he used this transportation method to visit customers and suppliers for his automobile windshield wiper motor rebuilding company. The companies he visited were spread over a wide area, and this made flying himself a reasonable choice for his business practice, considering how important it was for him to maintain close working contact with his suppliers.

What’s important to note is that it’s the circumstances that determine whether you get your deduction, not the particular courses you take. Ronald Beckley was an FBI special agent who had a pilot’s license before joining the FBI. He was sent on multiple missions as a pilot, but he was unable to take some missions because he lacked an instrument rating. Beckley took the courses he needed to perform his job better, but he also took several other courses that certified him as a commercial pilot and flight instructor. When his case went to court, Beckley was able to deduct the expense for the instrument rating, but not the expense for the other courses.[18] Those courses did not contribute to skills for his current position, and they qualified him to work in another field—as a commercial pilot.

Here’s a funny example. David Kohen failed a different part of the requirements. He had obtained his law degree, and rather than entering the profession, he chose to wait and pursue postgraduate courses in tax law. Unfortunately for Mr. Kohen, both the IRS and the court denied his deduction because he had never actually practiced law, and therefore was not in the business and did not have skills to “improve” or “maintain”.[19] That’s right—the postgrad in tax law could not justify and defend his tax deductions!

As mentioned, it’s best to be established in your business for several years before pursuing additional formal education. If you take the leap to leave your job while obtaining this education, you only have a chance at winning your deduction if you can prove that your absence was temporary. Unfortunately, the IRS and the courts disagree on the definition of “temporary absence”.

Robert Picknally benefited from this difference when he won his business education expense deduction.[20] After working for 10 years, he left for 3 in order to get a PhD. However, he was not able to get a job afterwards. In this situation, the IRS states the leave was not temporary because it lasted longer than one year (the IRS safe harbor limit). The courts, on the other hand, allow longer than a year if you can prove that you intend to stay in the same business after your temporary absence. Whether Picknally was actually able to find work in the same field did not matter, and the IRS even filed an acquiescence stating that the one-year-safe-harbor rule could be overridden when certain facts and circumstances make it appropriate.

Filing the Return

When you file your tax return, how you claim the deduction depends upon what kind of entity structure your business runs under. Here are a few possible scenarios:

  • Independent Contractor or Sole Proprietor—If you’re an individual business owner or freelancer, you use Schedule C of Form 1040 in order to claim your expenses. You’ll just put the business education deduction on this form with your other business expenses, and it will reduce your state income taxes, federal income taxes, and self-employment taxes.
  • S or C Corporation—When you operate as a corporation, things get a little trickier because you are considered an employee of your corporation. Because of this, you actually have two options for making the deduction. Either you can make the deduction as an individual, unreimbursed by your company for the business expense, or the corporation can make the deduction after reimbursing you for your employee business expense.

You do not want to take this first option, and here’s why: employees get the shaft when it comes to deducting business expenses. First, this option relegates your education costs to the miscellaneous itemized deductions category, meaning they are reduced by 2 percent of adjusted gross income.[21] Second, if you do not itemize deductions, you lose any benefit. And third, employee business expenses could trigger the alternative minimum tax (AMT), where they are disallowed.

The best choice for the owner of a corporation is to have the corporation take the deduction, after reimbursing you in a timely and appropriate manner. Your corporation gets a deduction, you get the cash (from your company), and you have no taxable income on this.[22] Perfect!

Now, here’s how you protect this perfect situation from the IRS. When your corporation deducts employee business expenses, it has the burden of proof on your behalf. So, your company should set up an accountable plan for providing reimbursements on these expenses. The accountable plan requires the employee to prove they complied with the rules of the plan before receiving reimbursement. It’s easy to do and could be something as simple as filling out and signing an expense report that states the employee met the qualification requirements for deductible education. You’ll also need the receipts. Providing this proof to your corporation builds protection both for you and your business entity.

Armed with this information, you’ll be able to choose educational options that benefit your business and are tax-deductible. But, you don’t really need to put up a fight—the government wants you to gain education. Typically, more educated individuals earn more money, and the government knows it shares in your financial growth. Education really is a smart investment, both for tax-savings and future success.

  1. Lori A. Singleton-Clarke v Commr., TC Summary Opinion 2009-182.
  2. “Nurse Outduels IRS over M.B.A. Tuition,” by Laura Saunders, The Wall Street Journal, January 9, 2010
  3. Coughlin v Commr., 203 F.2d 307 (2d Cir. 1953); 260 F.2d 80 (9th Cir. 1958).
  4. Walter G. Lage v Commr., 52 TC. 130 (1969).
  5. Reg. Section 1.162-5.
  6. Reisinger v Commr., 71 TC. 568 (1979).
  7. Reg. Section 1.162-5(a)(2).
  8. IRC Section 67(b).
  9. Rev. Ruling 74-78.
  10. Rev. Ruling 68-580.
  11. Reg. Section 1.162-5(b)(3)(ii).
  12. Patrick L. O’Donnell v Commr., 62 TC. 781 (1994), affirmed 519 F.2d 1406 (7th Cir., 1975).
  13. Thomas J. Cangelosi v Commr, TC Memo 1977-264.
  14. Robert C. Beatty v Commr., TC Memo 1980-196.
  15. Daniel R. Allemeier, Jr. v. Commissioner, TC Memo 2005-207
  16. Edward J. Kosmal v Commr., TC Memo 1979-490, affirmed per curiam, 82-1 USTC ¶9255 (9th Cir., 1982).
  17. Kenneth L. Knudtson v Commr., TC Memo 1980-455.
  18. Ronald J. Beckley v United States, 490 F.Supp. 123 (S.D. Ga. 1980).
  19. David M. Kohen v Commr., TC Memo 1982-625
  20. Robert Picknally v Commr., TC Memo 1977-321, Acq. AOD 1978-60.
  21. IRC Section 67(b).
  22. Rev. Ruling 76-71.