Employee Benefits Spotlight: Sec. 127 Educational Assistance Programs
To support workforce development and strengthen their benefits packages, businesses may want to consider sponsoring a tax-favored Section 127 educational assistance program. Recent changes under the One Big Beautiful Bill Act (OBBBA) expanded and permanently enhanced this benefit.
These plans can help your company attract and retain talent. And if you happen to employ an adult child, there's a notable tax break in the offing. Intrigued? Read on for further details.
Program Basics
Under Internal Revenue Code Sec. 127, your company may establish a program to provide each eligible employee with up to $5,250 in federal-income-tax-free educational assistance annually. However, the education must be for the employee — spouses and dependents who aren't employees don't qualify.
Sec. 127 programs can pay or reimburse most education-related expenses. This includes, but isn't limited to, undergraduate or graduate tuition, fees, books, and eligible supplies and equipment. Covered expenses don't have to be job-related. What's reimbursable is left to the employer's discretion when setting up the plan.
The program can't cover tools or supplies (other than textbooks) that participants can keep after completing a course, and it can't cover meals, lodging or transportation. In addition, the program generally can't cover any course or education involving sports, games or hobbies (unless they relate to the company's business).
Along with being tax-free for participants, qualifying payments or reimbursements are tax deductible for your business as employee compensation expenses and payroll-tax-free. You may choose to pay or reimburse employees for prohibited expenses outside of a Sec. 127 program, but those amounts will be treated as additional employee compensation subject to federal income and payroll taxes.
OBBBA Enhancements
As mentioned, the OBBBA gave Sec. 127 programs a boost. And it did so in a couple of ways. First, subject to the $5,250 annual limit, programs can make tax-free payments or reimbursements to cover principal and interest payments on participants' qualified education loans. This provision, enacted in 2020, was scheduled to expire after 2025, but the OBBBA made it permanent.
In addition, the $5,250 annual limit had been set in stone for many years. Under the OBBBA, it will be adjusted annually for inflation starting in 2027.
Program Qualification Rules
To establish a compliant Sec. 127 program, your business must create a separate written plan document that stipulates, among other things, that the program is for the exclusive benefit of employees to provide them with educational assistance. And you must give employees reasonable notification of the program's availability and terms.
In addition, the program can't discriminate in favor of highly compensated employees or employees who are dependents of highly compensated employees. Generally, making all staff members eligible for the program will prevent discrimination problems. Your business doesn't have to pre-fund its program — you may pay or reimburse eligible expenses as they're incurred.
Important: You can't offer employees the choice between tax-free educational assistance and other taxable compensation, such as wages. This means a Sec. 127 program can't be included in a Sec. 125 cafeteria plan.
Stipulations for an Owner's Employee-Child
There's another important rule to follow when setting up a Sec. 127 program: You can't funnel more than 5% of annual benefits to more-than-5% owners or those owners' spouses or dependents who are also employees. (See "Ownership Attribution Rules" below.)
An employer that offers a Sec. 127 plan can provide coverage for employees who are children of a company owner. However, to qualify, such individuals must be age 21 or older and legitimate employees. They also can't be the business owner's dependent or a more-than-5% owner of the company.
At first glance, those stipulations may seem difficult to meet. But many business owners have college-age children who split their time working for the company and attending undergraduate or graduate school. Plus, working in the business means an employee-child has income, making it more likely he or she isn't considered a dependent under federal income tax rules.
Increased Attention
Sec. 127 education assistance programs are receiving increased attention in light of the OBBBA's enhancements. If your business has yet to implement one, now may be a good time to consider doing so — especially if you might be able to cover your employee-child. Your tax advisor can help you explore the idea further.
Ownership Attribution Rules If your company employs one of your children who's age 21 or older and appears to otherwise qualify for a Section 127 program, you must watch out for the more-than-5% ownership rule. (See main article.) It applies to 1) actual ownership, such as holding shares of a C or S corporation or interest in a partnership that the child directly owns in his or her own right, or 2) attributed (indirect) ownership in the business under the "attribution" rules. For C or S corporations, ownership is attributed to your employee-child if he or she:
An under-age-21 individual is considered to own any stock owned directly or indirectly by a parent. Although there's no such attribution rule for those age 21 or older, attribution can occur when an adult employee-child has actual ownership of more than 50% of the employer-corporation's stock. But such ownership would likely disqualify a Sec. 127 program before it even reaches the stage of having to comply with the corporate stock ownership attribution rules. The bottom line is, as long as your otherwise-eligible employee-child doesn't own more than 5% of your corporation's stock, he or she will likely qualify to participate in your Sec. 127 program. That means your company can annually fund up to $5,250 of his or her eligible education expenses income-tax-free. But wait, you might say, what if my business is unincorporated? That means you operate it as a:
In that case, you still have to worry about the more-than-5% rule, but the concept is the same. Your otherwise-eligible employee-child should be able to participate in your Sec. 127 program as long as he or she doesn't have a more-than-5% ownership stake in your company. |