Dangerous entity scams targeting traders, part 3: Education expenses are a problem in dual-entity schemes

March 3, 2010 | By: Robert A. Green, CPA

Stay clear of promoters advocating expensive dual-entity schemes in order to deduct educational costs; it costs much more than the related tax benefits and we offer a better solution. 

Here’s the problem: Aspiring traders often want to take online trading classes before setting up either a trading business (qualifying for trader tax status) or an active investment activity (which may fall short of trader tax status). 

As we pointed out in “Dangerous entity scams targeting traders, part 2,” it’s very difficult to achieve a tax deduction for pre-business and investment education expenses. If you qualify for trader tax status first, and then take trading classes, they probably qualify for business deduction treatment. If you qualify for trader tax status soon after the education classes, a reasonable amount of education may be squeezed — under limited conditions — into Section 195 start-up costs, which have limited business deductions after business commencement. If you don’t qualify for trader tax status before or after, Section 212 investment expenses are allowed, but they can’t include Section 274(h)(7) expenses: including one-week education classes, and travel to classes, seminars, trade shows and conventions. Online classes and longer course schedules may qualify for Section 212 investment expense treatment. 

We think the promoters flout these basic rules about education deductions and they make blanket promises to traders offering full business deduction treatment for all pre-business or even pre-investment education classes for up to 18 months before the trader even starts active trading. We explained some education expense problems in part 2; here we discuss using dual-entity schemes to cover up these problems. 

C-corps allow tax-free fringe benefit plans like a Section 127 education assistance plan for employees, whereas pass-through entities, including general partnerships, LLCs and S-Corps do not for owners of 2 percent or more of the equity. Dual-entity promoters usually don’t even offer a Section 127 education assistance plan. But in the event you are offered a one, read on to understand how they work, and learn why they aren’t recommended in our view. 

Section 127 and C-corps
A Section 127 plan is limited to an exclusion of income in the amount of $5,250 per year. But few traders are able to adhere to Section 127’s strict rules, plus the expenses of the scheme are greater than the tax benefits anyway. The trader will wind up owing taxes rather than saving taxes. However, it’s useful to understand the rules of Section 127 because they point out the pitfalls traders are falling into with these schemes. 

Traders pay for education costs in the range of $5,000 to $25,000. If a C-corp reimburses an individual for this education cost, it’s considered a fringe benefit to the trader and therefore taxable income to that individual. According to tax law, the individual trader is the one who is getting the benefit of education, so it’s as if the corporation paid the individual the benefit of the education (as a dividend or as salary, either of which are taxable to the individual). 

The individual is entitled to exclude up to $5,250 from income per year only with a C-corp and Section 127 plan in place before the education was initiated. If a trader was reimbursed for $15,250 of education, the trader would have $10,000 of net taxable income and that excess could not be deferred to later years under the Section 127 plan. It’s very rare that a trader would have a C-corp and Section 127 plan in place before attending classes, so the taxable income would be $15,250 if there is no Section 127 exclusion. 

Many traders don’t realize they are falling into a tax trap here. If they executed one of these schemes, the IRS (during an exam) can force the trader to report taxable income for the entire amount of the education expenses reimbursed by the C-corps, leading to high back taxes, interest and penalties.

The promoters claim the second entity LLC can bail them out of this problem, yet they are wrong again. The scheme usually calls for the LLC to pay the C-Corp an administration fee — intended to cover the C-Corp’s education-related expenses — which is treated as taxable compensation to the individual trader owner/employee. 

Many promoters claim the LLC doesn’t need to qualify for trader tax status and as we explained in part 1, they are wrong. Without trader tax status, the LLC has Section 212 investment expense treatment passed through to the individual owner. There are several tax problems in this case. The individual winds up with taxable income from the C-corp and a restricted investment expense passed through from the LLC partnership tax return. 

Add it up and the individual has taxable income not fully offset by investment expenses — limited to 2 percent of AGI and added back for AMT. That leads to higher taxes. The IRS also may bar the Section 212 expense treatment, considering it a disguised education deduction that doesn’t qualify for Section 212 because it fails under Section 274(h)(7) travel education rules. 

Even if the LLC qualifies for trader tax status later in the tax year, in the best-case scenario, the trader has zero change in gross income. The individual trader may be able to offset his taxable income from the C-corp by a business deduction passed-through from the LLC. Again, we think the IRS may challenge this scenario as a sham transaction. 

Examples and more details about Section 127 plans
First, it’s important to note that Section 212 (investment expense treatment) applies only to individuals, not corporations. So, can an individual simply use a C-corp to navigate around the education tax-deduction problems discussed in part 2 of our articles?

Suppose a C-corp established in February 2010 pays pre-business education expenses soon thereafter in February 2010 either directly or by reimbursement to the owner/manager of the C-corp. The trader forms a husband-and-wife LLC which qualifies for trader tax status in October 2010. The trading-business LLC pays the C-corp an administration fee in December 2010 to cover the C-corp’s expenses (including an attempt to deduct pre-business education) and generate a sufficient small profit for the C-corp. 

The problem with the C-corp setup is the individual trader is benefiting from the education, so it’s as if the corporation paid the individual for the education (as a dividend or as salary, either of which are taxable to the individual). The individual must either find a legal way to deduct the education expenses or report its value as income. 

As we discussed earlier, Section 127 allows an employee to exclude up to $5,250 per year for education provided by an employer. This applies both to reimbursements received from an employer as well as the fair market value of educational assistance paid or provided directly by the employer. (This is the case only if the requirements of Section 127 are followed, including the existence of a written plan.) If the trader is a shareholder but not an employee of the C-corp, we would argue that all of the education should be taken into income.

Here is how the C-corp, LLC and individual owner should be handled tax-wise. The C-corp reports revenues for the administration fee received from the LLC and deducts officer salary paid to its owner/manager for the education expenses. The individual may exclude up to $5,250 per year; expenses paid or reimbursed over this amount are taxable income. For this reason, most C-corps will probably limit education-related salary payment to $5,250 per year. 

If an individual takes educational courses costing more than $5,250 in one year, he can’t defer the excess to later years. The individual must take the excess into income, which can be a real downside to this idea. 

So far, it sounds like under limited conditions, a trader might benefit from a C-corp to deduct and exclude up to $5,250 of educational assistance per year. But keep in mind it’s really only the first year of a trading business for which this strategy sounds interesting. Once a trading business is established, all business education is fully deductible by the LLC or sole proprietor trader as Section 162 business expense treatment. After the first year, there’s no cap on business education deductions. 

Technically, this Section 127 educational expense strategy — under perfect and rare conditions — could deliver just the initial year’s education exclusion limit of $5,250. But, it costs much more than the related tax savings on the $5,250 exclusion (figure around $2,000 with a 40 percent federal and state marginal tax rate). Plus, the IRS could challenge this scheme. 

In a perfect world, the C-corp is formed before paying for education courses, allowing a deduction for educational expenses, which are reported as salaries to the individual employee/owner. The LLC must qualify for trader tax status later in the year, and then it can pay the C-corp an administrative fee equal to the cost of educational expenses (plus more for a reasonable profit), so that the C-corp can offset the fee income with the educational deduction. The employee will have to recognize income to the extent the educational expense exceeds $5,250. The total benefit to the scheme is just $5,250, if all things are handled correctly.

In reality, this Section 127 education expense scheme fails because it’s rarely deployed in the correct order or proper manner. The C-corp, Section 127 plan and payroll all must be setup and deployed in advance of the education courses being taken. Usually traders don’t know about this plan until after they have started their trading classes. 

Even if a trader knows about this before taking course, it’s not worth pursuing in our view. Remember, the best course of action if you are knowledgeable of the rules in advance is to qualify for trader tax status before taking education classes and then receive an unrestricted business deduction. 

Even if the IRS accepts the scheme, the cost/benefit savings don’t add up. This scheme costs thousands of dollars, more in cost than the tax-savings on the $5,250 Section 127 education expense exclusion. Keep in mind that the C-corp has state filing fees and annual report charges (which vary by state), double-taxation (since the C-corp needs to show a reasonable profit), and there are professional fees for preparing the C-corp tax returns, the payroll tax returns and setting-up and maintaining the Section 127 fringe-benefit plan. This scheme is very profitable for promoters but not traders. 

Our tax solutions for deducting pre-business education costs deliver much greater tax benefits, under an easier safer, and wiser approach. Plus, our costs are far lower too. 

Our solution
Take your education classes and then consider your options with no up-front commitments. When a trader feels he will qualify for trader tax status in the near future, at that time the trader can form one simple pass-through entity like a general partnership or LLC. A second C-corp is not needed. The trader also doesn’t need payroll (taxes and compliance costs) or the formation of a Section 127 plan. Our solution has entity formation costs and preparation fees for one simple entity; dual entities double the related costs.

You can attempt to squeeze the pre-business education costs — as we suggested in part 2 of this series — into Section 195 start up costs. Perhaps the pre-business education amount is $10,000. The first $5,000 of start-up costs is a first-year expense election and the balance is deductible over 15 years. That’s a greater deduction than the $5,250 Section 127 limit in year one only. 

Our solution has some risks in the IRS accepting the education as part of Section 195 (see part 2). The IRS won’t challenge the type of education in the Section 127 plan — as it’s not a factor — but again the cost of the dual-entity Section 127 scheme is far greater than any potential tax savings, so it’s better to skip that approach entirely. 

Bottom line
Why should traders spend thousands of dollars before taking classes for a scheme that delivers fewer tax benefits compared to our solution? Our solution can be deployed after-the-fact, when a trader knows he has a viable trading business. Plus our plans cost far less and deliver many more tax breaks.