What are my options as a business owner?
As a business owner, you have unique college planning opportunities. If you are in a high tax bracket, it may be advantageous for you to shift assets or income to your child, who will typically be in a lower tax bracket. Generally, you can shift business income to your child using one of the following strategies:
- Gift company stock to your child
- Transfer a partnership or S corporation interest to your child
- Arrange a gift-leaseback transaction with your child
- Put your child on the company payroll
The common theme in all of these strategies is shifting business assets or income to someone in a lower tax bracket to take advantage of lower tax rates.
Gift company stock
If you plan to sell appreciated company stock to pay for college, you may be able to shift the resulting capital gain into a lower tax bracket by gifting the stock to your child and allowing him or her to sell it. Your child can then use the sale proceeds to pay college expenses. There may be some tradeoffs, however.
First, the kiddie tax may limit your tax savings. Under the kiddie tax rules, a child’s unearned income over a certain threshold ($2,300 in 2022) is taxed at parent income tax rates. The kiddie tax generally applies to children under age 18 and full-time college students under age 24 whose earned income doesn’t exceed one-half of their support.
Second, this strategy may have gift tax implications if the stock will be sold for more than the annual gift tax exclusion ($16,000 in 2022) for individual gifts and $30,000 for joint gifts).
Third, this strategy might reduce your child’s financial aid award. Under the federal government’s methodology for determining financial aid, child assets (whether actual shares of stock or sale proceeds in a savings account) are weighed more heavily than parent assets. Accordingly, most college advisors recommend that your child hold few assets in his or her name as of the date the financial aid application is completed.
Fourth, it may be difficult to find a market for stock in your closely held business. A pre-arranged sale to another family member might be deemed a sham transaction by the IRS. But if the stock is sold to someone outside your circle of family and friends, your family may end up sharing ownership of the business with a stranger. Seek the advice of an attorney or tax advisor when selling to a close family member so the transaction won’t be considered a sham by the IRS.
Transfer a partnership or S corporation interest
If your business is treated as a partnership or S corporation for tax purposes, you may be able to shift income to your child by transferring an interest in the business to him or her. After you have transferred an interest in the business to your child, he or she can accumulate distributions of business income (unearned income) to cover college expenses. However, the kiddie tax may limit your tax savings and this strategy might reduce your child’s financial aid award (as described in previous section).
Example(s): Anne owns a temp agency and her business is set up as an S corporation. The value of the business is $400,000. Anne is the sole shareholder and is in the top tax bracket. Anne wants to start a college fund for her son Noah who is eight years old. Anne gifts $16,000 worth of nonvoting stock to Noah every year for 10 years (Anne will avoid federal gift tax by limiting her gifts to the annual gift tax exclusion amount). During the early years, Noah will receive dividends on the S corporation stock that can accumulate to cover his college costs. However, Noah’s tax savings will also be limited due to the kiddie tax rules.
However, the IRS has rules governing who is eligible to be a shareholder in an entity treated as an S corporation for tax purposes. Consult with an attorney or tax advisor to be certain that making your child a shareholder of your S corporation will not jeopardize the corporation’s tax treatment. In addition, to be recognized as a partner in a partnership, your child must have the capacity to enter into a partnership contract in your state. Generally, your child must have reached the age of majority or acted through a duly authorized guardian, conservator, or trustee. Consult an attorney or tax advisor who is familiar with the laws of your state.
In addition, there are costs associated with this strategy. An attorney must draft a partnership agreement. Documents and tax returns must be filed. Appraisals must be made. Transfers must be documented and appropriate titling instruments prepared. Further, if a trust is recommended, trust documents must be drafted. Consider these expenses when evaluating your potential tax savings. In the case of an S corporation, you will need a corporate attorney to handle the transfer of stock and, if needed, the issuance of nonvoting shares.
Arrange a gift-leaseback transaction
A gift leaseback is a transaction in which one party gifts property to another party and then leases the property back. The discussion here focuses on a parent/business owner using a gift-leaseback arrangement to transfer an asset to a child in order to reduce the family’s overall federal income tax liability.
In a gift-leaseback transaction, the typical strategy is to give a substantial business asset (e.g., a building, land, equipment) directly to your child or to an irrevocable trust for the benefit of your child. A trust is often used when parents are uncomfortable gifting a substantial asset directly to their child. You then enter into a fair market lease with your child (or the trust) to lease the asset back. Your child receives income from the lease payments, and you can deduct the lease payments as a business expense.
Example(s): Dr. Robinson has a successful medical practice and owns the medical building in which he practices. He is in a high tax bracket. He has a young child for whom he has would like to start a college fund. Dr. Robinson could gift the building to an irrevocable trust for the benefit of his child. He could then lease the building back from the trust at a fair market rental. These payments “flow through” the trust to the child.
The main benefit of a gift-leaseback from parent to child is that parents can divert income (in the form of lease payments) from themselves to their child, who is probably in a lower income tax bracket. The child can then use this money (and the resulting tax savings) to save for college. And assuming the gift-leaseback transaction is structured properly, parents can deduct the lease payments as a business expense.
The main drawback of a gift-leaseback is that child assets are counted more heavily than parent assets for purposes of financial aid and you (the donor) may owe gift tax depending on the value of the asset being gifted to your child. If the value of the gift is less than the annual gift tax exclusion amount ($16,000 for individual gifts or $32,000 for joint gifts in 2022), you will avoid federal gift tax. If the gift is more than this amount, you may owe gift tax (but any gift tax owed may be offset by your applicable exclusion amount).
Also, keep in mind that the IRS pays close attention to gift-leaseback transactions to determine if such transactions are in fact genuine, that is, based on prevailing market values and rental rates. This is especially true for transactions between related parties like parent and child. This means that a qualified independent appraiser should be used to determine both the fair market value of the asset being gifted and what a fair market rental should be for that asset. In addition, there should be a written lease agreement with standard terms for that type of property. One of the provisions of the lease should be a penalty provision for breaches of the agreement, such as a specified penalty for late lease payments. These attributes signify to the IRS that the gift-leaseback transaction is not a sham.
If you give the asset to a trust instead of directly to your child, the trustee of the trust should be independent from you and other family members. Parents should also avoid naming their attorney or accountant as the trustee. Preferably, the trustee should be completely independent (for example, a bank or an independent fiduciary). Also, if a trust is used, it should not contain a provision allowing the property to come back to you at some point in the future (called a reversionary interest). If there is such a provision, the IRS may not consider this arrangement to be a true gift, in which case the lease payments would not be deductible.
And there are some tax consequences to keep in mind. As mentioned, if the gift-leaseback is structured properly, the parent can fully deduct the lease payments as an ordinary and necessary business expense (assuming that the leased asset is used in the parent’s trade or business). However, the child must report the lease payments as income, but depending on the asset acquired, he or she may be able to claim depreciation deductions with respect to the asset and offset some of the lease income. Finally, as noted previously gift tax may be due depending on the value of the asset being gifted. Consult an attorney or tax advisor for more information or for help in implementing a gift-leaseback.
Put your child on the company payroll
You may be able to shift income into a lower tax bracket by putting your child on your company’s payroll. Your child can work in the family business, receive a weekly paycheck, and accumulate money for college.
Example(s): Dan owns a closely held business and is in the top tax bracket. He hires his daughter Molly to work in the family business. Like other employees, she receives a weekly paycheck. She works 15 hours per week at $12 per hour and earns $180 per week. At the end of 50 weeks, Molly earns $9,000. Because she is in a lower tax bracket, Molly will have more money available to put toward college than if Dan had earned that $9,000.
Check the child labor laws in your state to determine at what age, and for how many hours, your child may legally work. Also beware that if you pay your child more than a reasonable amount of compensation, the IRS may deem the excess a gift.
This strategy has several strengths. First, the kiddie tax does not apply because this income is earned income as opposed to unearned income. Second, gift tax does not apply because your child is earning his or her own income. third, your child will be eligible to open an IRA because he or she will have earned income. Fourth, a child under age 18 who works for his or her parents in a trade or business will not owe Social Security or Medicare taxes if the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child. And finally, by working in the family business, your child gains practical work experience and may learn some transferable skills.
However, as discussed above, if your child is seeking financial aid, this strategy could reduce his or her award because child assets are counted more heavily than parent assets in the federal government’s financial aid formula. If your child has substantial savings from working at the family business, one option is to have your child open an IRA, which is not counted as an asset for financial aid purposes by either the federal government or colleges. Also, withdrawals from an IRA that are used for college expenses aren’t subject to the early distribution penalty.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The information provided is not intended to be a substitute for specific individualized tax planning or legal advice. We suggest that you consult with a qualified tax or legal professional.
LPL Financial Representatives offer access to Trust Services through The Private Trust Company N.A., an affiliate of LPL Financial.
This article was prepared by Broadridge.
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