2.11 Educational Benefits for Employees’ Children

Private foundations.

The IRS has published guidelines for determining whether educational grants made by a private foundation established by an employer to children of employees constitute scholarships. An objective, nondiscriminatory program must be adopted. If the guidelines are satisfied, employees are not taxed on the benefits provided to their children. Advance approval of the grant program must be obtained from the IRS.

IRS guidelines require that:

• Grant recipients must be selected by a scholarship committee that is independent of the employer and the foundation. Former employees of the employer or the foundation are not considered independent.
• Eligibility for the grants may be restricted to children of employees who have been employed for a minimum of up to three years, but eligibility may not be related to the employee’s position, services, or duties.
• Once awarded, a grant may not be terminated if the parent leaves his job with the employer, regardless of the reason for the termination of employment. If a one-year grant is awarded or a multi-year grant is awarded subject to renewal, a child who reapplies for a later grant may not be considered ineligible because his parent no longer works for the employer.
• Grant decisions must be based solely upon objective standards unrelated to the employer’s business and the parent’s employment such as prior academic performance, aptitude tests, recommendations from instructors, financial needs, and conclusions drawn from personal interviews.
• Recipients must be free to use the grants for courses that are not of particular benefit to the employer or the foundation.
• The grant program must not be used by the foundation or employer to recruit employees or induce employees to continue employment.
• There must be no requirement or suggestion that the child or parent is expected to render future employment services.
• A percentage test generally must be met. The number of grants awarded in a given year to children of employees must not exceed (1) 25% of the number of employees’ children who were eligible, applied for the grants, and were considered by the selection committee in that year; or (2) 10% of the number of employees’ children who were eligible during that year, whether or not they applied. Renewals of grants are not considered in determining the number of grants awarded.

Caution

Primary Purpose Determination

If all guidelines other than the percentage test are satisfied, the IRS will determine whether the primary purpose of the program is to educate the children. If it is, the grants will be considered scholarships or fellowships; if it is not, the grants are taxed to the parent-employees as extra compensation.

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If all of the above tests other than the percentage test are met, the educational grant program can still qualify if the facts and circumstances indicate that the primary purpose of the program is to provide educational benefits rather than to compensate the employees.

Educational benefit trusts and other plans.

A medical professional corporation set up an educational benefit plan to pay college costs for the children of “key” employees. Children enrolled in a degree program within two years of graduating from high school could participate in the plan. If an eligible employee quit for reasons other than death or permanent disability, his or her children could not longer receive benefits except for expenses actually incurred before termination. The company made annual contributions to a trust administered by a bank. According to the IRS, amounts contributed to the trust were a form of pay to qualified employees, because the contributions were made on the basis of the parents’ employment and earnings records, not on the children’s need, merit, or motivation. However, the employees could not be taxed when the funds were deposited because the children’s right to receive benefits was conditioned upon each employee’s future performance of services and was subject to a substantial risk of forfeiture. Tax is not incurred until a person has a vested right to receive benefits; here, vesting did not occur until a child became a degree candidate and incurred educational expenses while his or her parent was employed by the corporation. Once the child’s right to receive a distribution from the plan became vested, the parent of the child could be taxed on the amount of the distribution. The company could deduct the same amount.

The Tax Court and appeals court have upheld the IRS position in similar cases.