Shifting Income to Fund a College Education

by | Aug 8, 2022 | Tax Planning

Gifts of Business Interest

In previous posts, we covered methods of deferring investments in the equity markets such as Qualified Tuition Plans (529 Plans). However, a better strategy is to defer all of the child’s income taxes to their college years. There are income-shifting techniques that can be employed to do this. The following techniques will be reviewed in this post:

• Gifts of S Corporation stock

• Gifts of Limited Liability Company interests

• Gifts of family partnership interests

• Gifts to a Qualified Personal Residence Trust

S Corporation to Shift Income

Gifts of stock in a family Subchapter S corporation can be used to shift income to children and reduce the parent’s estate. The child does not have to contribute income-producing capital to obtain a legitimate stock ownership. If the child is a minor, the stock can be held in a trust (a Qualified Subchapter S Trust or an Electing Small Business Trust) or custodial account (UGMA/UTMA). If the child is a student under age 24, the child’s Subchapter S corporation income will be subject to the Kiddie Tax rules.

Advantages:

  1. The child can use income from the stock to fund college.
  2. The parent has control while stock is in trust or custodial account.
  3. The value of the stock will be considered a gift and will be eligible for the annual gift exclusion.
  4. The stock will be removed from the gross estate of the donor.

Disadvantages:

  1. If the child is under age 24, the S corporation stock income allocated to the child will be subject to the Kiddie Tax rules. S stock held in either a custodial account or a Qualified Sub S Trust (QSST) will pass income through to the child. S stock held in an Electing Small Business Trust (ESBT) does not pass through income to the beneficiary, but the trust is taxed at a flat 35% on S income.
  2. When the trust or custodial account terminates, the child will have complete control of the stock and income generated from the stock.
  3. The stock may produce more income than the child needs for college.
  4. How will the stock be redeemed or reacquired by parent?

• Stock redemptions within 10 years of a gift of the stock are converted to dividend status per IRC Sec. 302(c)(2)(B)(i).

• This produces ordinary dividend income to the shareholder if S Corporation has former C Corporation earnings and profits (E+P).

• This produces an S distribution (an extraction of the AAA account and tax-free return of basis) if S has no E+P.

  1. If the taxpayer has several children, gifts of family S Corporation stock to all children can result in long-term divergence of stock ownership vs. employment/ management roles (e.g., three children own some portion of S Corporation but only one child is an active employee/successor owner).

Limited Liability Company to Shift Income

A Limited Liability Company (LLC), because of its tax status as a partnership, provides great flexibility in allocating interests in profits and capital and therefore can be used to shift income to children and grandchildren. There are generally no restrictions on the type of assets that can be used to fund a family LLC. The assets could be stocks, real estate, business assets, or interests in partnerships.

The income shifted to the child could be used to fund college with no loss of control. A LLC allows the management of the business to be concentrated in the hands of one manager or just a few managers without causing the transferred interest to be included in the owner/manager’s estate.

Advantages:

  1. Provides flexibility in allocating profits to the child.
  2. No restriction on the type of assets that can be used to fund the LLC (although the IRS will contest the use of discounts in valuing LLC units where the LLC holds marketable securities).
  3. Control over the assets can be kept by the managers (parents).
  4. Income is shifted from the donor of the LLC interest to the child.
  5. The value of the LLC interest is a gift to the child and is eligible for the annual gift exclusion, with the possibility of discounted valuation of the LLC interests due to minority status and lack of marketability.
  6. The value of the LLC interest will be removed from the donor’s estate.

Disadvantages:

  1. The child has an ownership interest in the LLC. Unless the parent want to have the child permanently own this interest, an eventual acquisition plan or redemption strategy is required.
  2. More income than the child needs for college may be generated.
  3. The child’s income will be subject to the Kiddie Tax rules if under 24.

Family Partnership to Shift Income

Typically, a family limited partnership has the parent as the general partner and the children as limited partners. The limited partners cannot make investment, business, or management decisions. The parents make annual gifts of limited partnership interests to a child.

The tax savings and income from the partnership are used to fund the child’s college education while the parents keep control of the underlying assets.

Advantages:

  1. The income generated from the child’s share of the partnership
    is taxed at the child’s lower rates.
  2. If the parents are the general partners, they control the amount of distribution to the child.
  3. The value of the partnership interest is a gift to the child and is eligible for the annual gift exclusion.
  4. The value of the partnership interest will be removed from the donor’s estate.

Disadvantages:

  1. The child has an ownership interest in the business. Does this make long-term business sense, especially if the child is expected to be inactive in the business? How does the child eventually sell this asset and to whom?
  2. More income than the child needs for college may be generated.
  3. The child’s income is subject to the Kiddie Tax rules if the child
    is under age 24.

Qualified Personal Residence Trusts for a Vacation Home (QPRT)

A QPRT is created when a parent transfers their residence into a trust and retains the right to use the residence for a specific number of years (Reg. 25.2702-5). At the end of that time, the residence is transferred to the beneficiary children. When the children receive the residence, they can use the rent or sale proceeds to pay for college costs. When the residence is transferred to the trust, a taxable gift is made, but the value of the gift is discounted for the present value of the donors retained period of usage.

Often, beneficiaries purchase life insurance on the grantor’s life to insure against the risk that the residence will be returned to the estate if the grantor dies during the term of the QPRT. The life insurance proceeds can be used to pay the additional estate taxes should the grantor die.

Advantages:

  1. The residence plus any future appreciation is removed from the donor’s estate.
  2. During the term of the trust, the grantor/parent retains grantor trust income tax treatment (i.e., tax deductibility of real estate taxes).
  3. The children can sell or rent the house and use the proceeds for college.

Disadvantages:

  1. Beneficiaries acquire the residence with the same tax basis as the grantor.
  2. The beneficiaries cannot use the $500,000 exclusion for the sale of a personal residence.
  3. The parents will have to pay rent if they live in the house after the expiration of the trust term. This rent is non-deductible to the parents, but taxable to the children.

Summary of Parent Status

Individuals in certain circumstances should adopt income shifting strategies to maximize a child’s tax capacity. The advantages and disadvantages of the investments used to hold the assets shifted to a child need to be weighed carefully. The timing of the distributions for college costs needs to be precise.