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If I Hire My Kids, Can I Give Them Tax-Free Education Benefits?

Pink piggy bank with graduation hat

Yes! Potentially, in two different ways. Here’s how.

Payments for Job-Related Education

Your business can reimburse an employee for certain education expenses, and the reimbursements will be treated as tax-favored working condition fringe benefit payments.

  • For the employee, that means the reimbursements are free of any federal income tax hit or federal employment tax hit. Nice!
  • For your business, that means the reimbursements are deductible as employee compensation expense. Also nice!

This favorable federal tax treatment is generally allowed if

  • the education is required by your business, or by law or regulation, for the employee to retain his or her current job; or
  • the education maintains or improves skills required in the employee’s current job.

More good news. When the preceding tests are passed, this favorable tax treatment is available for any employee, including one who happens to be related to the employer’s owner, such as your 22-year-old employee-child.

Favorable working condition fringe benefit tax treatment is also available when your business pays for education that passes the preceding tests by making direct payments to the educational institution on behalf of the employee.1

If your business pays for education that does not pass the preceding tests—such as education that prepares the employee for a new business or profession—the payments count as taxable wage compensation for the employee (unless the payments are run through a Section 127 educational benefits plan, as explained later). In either case, your business can deduct the costs as employee compensation expense.

Undergraduate Degree Program Cannot Be Work-Related Education

The IRS says an undergraduate degree automatically trains you for a new profession or business.

Therefore, reimbursements or payments by your business for costs for an employee, including your employee-child, to obtain a Bachelor of Arts or a Bachelor of Science cannot qualify as tax-free working condition fringe benefit payments. Presumably the same is true for costs to obtain a community college associate degree.

Sadly, the Tax Court has repeatedly agreed with the IRS on this issue. So, if your business pays for an employee to obtain an undergraduate degree, the payments will represent taxable compensation for the employee. But your business can deduct the costs as employee compensation expenses.

Key point. As stated above, the general rule is that employer reimbursements for or payments of undergraduate degree program costs won’t qualify for tax-free working condition fringe benefit treatment. But the IRS informally says that each course in a program must be evaluated separately to see if an employer’s coverage of the cost of that course can qualify as a tax-free working condition benefit.

For instance, if your employee-child’s work involves accounting, your business could apparently treat reimbursements for his or her undergraduate accounting courses as tax-free working condition fringe benefit payments, even though those courses are part of an undergraduate degree program.3

MBA Program Can Be Work-Related Education

The IRS has also taken the position that a Master of Business Administration (MBA) trains you for a new profession or business.

So, according to the feds, employer payments to cover the costs of obtaining an MBA cannot qualify as tax-free working condition fringe benefit payments.

Thankfully, several Tax Court decisions say tax-free working condition fringe benefit treatment should apply when the MBA program maintains or improves skills used in the employee’s current profession or business. If the MBA also happens to enhance the employee’s resume and increase his or her earning potential, that’s not a problem according to the Tax Court.4

For instance, if your employee-child’s work involves management and administrative matters, your business can apparently treat payments to cover his or her MBA program costs as tax-free working condition fringe benefit payments.

Payments for Student Loans

Through the end of 2025, a Section 127 plan can also make tax-free payments to cover principal and interest on any qualified education loan taken out by a participating employee. The payments are subject to the $5,250 annual limit, when combined with any other payments in that year to cover the employee’s eligible education expenses.6

Loophole for Payments to Benefit Your Employee-Child

You might think the Section 127 plan rules will mean no dice for employees who happen to be children of business owners. Not necessarily true. There’s a loophole for any employee-child who is

  • age 21 or older, and a legitimate employee of the business; and
  • not a dependent of the business owner (that would be you); and
  • not a more than 5 percent owner of the business.

Age-21-or-older status is pretty likely when the employee-child spends substantial time working in the parent’s business and attends school only part-time.

Also, when the employee-child is working in the business and also attending graduate schedule, the child likely has age-21-or-older status.

Working in the parent’s business means the employee-child has an income, making it more likely he or she will not be a dependent under the federal income tax rules. Under those rules, a child is a dependent only if the child does not provide over half of his or her own support.7

Bottom line. What starts off looking like a narrow loophole ends up being wide enough to drive a truck through for many small business owners. Good!

Dodging the Bullet of 5 Percent Ownership

To avoid disqualification of your employee-child under the rule stated in item 6, he or she cannot be a more than 5 percent owner of your business.

Bottom line. Unless your over-age-21, non-dependent employee-child directly owns more than 5 percent of the stock in your C or S corporation, he or she should dodge the bullet of 5 percent ownership.

If so, your C or S corporation can set up a Section 127 plan and can start paying for and deducting your employee-child’s eligible expenses right now. Your employee-child will owe zero federal income tax and zero federal employment tax on up to $5,250 per year collected from the Section 127 plan. Nice!