Category: Entrepreneurship

Year-end tax planning with a college-bound kid? Common tax moves for your small business that can save you taxes but may cost your chances for financial aid.

As we approach year-end, there’s no shortage of articles on different tax moves one can make. Your CPA or tax professional may have suggested some to lower your tax bill. When you have a kid about to go to college, however, things can get tricky. Your well-intentioned CPA or tax professional may end up costing you aid and raising the cost of college!

*** Please note that this article is not intended as tax advice. Please consult your own tax professional or financial advisor to discuss your specific circumstances. ***

Before we detail the differences between taxes and financial aid, it’s important to understand how your financial information is used in the financial aid process. Families submit their income and asset information typically using the FAFSA, and for some schools, the CSS Profile form. The colleges then use the information on those forms, applying different formulas, to determine how much the family can afford for college each year, known as the Expected Family Contribution, or EFC. In the formulas, income is a far bigger factor than assets.

Using the EFC, colleges then determine whether the family qualifies for need-based aid. This type of aid can be in the form of grants, loans, or even work-study. Because these types of aid are based on a family’s financials, some families think they “make too much money to get aid”.

Let’s go a little deeper. The income information used on the financial aid forms is based on the family’s tax return (parent and student, if filed). On the surface, then, anything you might do to save taxes – lowering income, increasing deductions, etc. – would be a smart move. As a famous announcer on a well-known sports TV channel says, “Not so fast my friend”.

There are 3 key areas where taxes and financial aid differ for self-employed and small business owners.

First, the most common area for reducing taxable income is to contribute to a tax-deferred retirement plan, such as a 401k, 403b, or an IRA. Lower taxable income, save on taxes today, and save for retirement – it seems to be a smart financial move. For financial aid, this person would have just hurt themselves. In the simple example below, a parent increases their retirement plan contribution: 

In this simplified example with an assumed tax rate of 10%, increasing the retirement plan contribution results in increasing, not decreasing, the income for financial aid purposes. Higher-income equals higher EFC, which lowers your chances of financial aid.

Retirement plan contributions could be amounts put into a 401k, SEP, SIMPLE, or a personal IRA.

Why would retirement plan contributions be added back? Financial aid income counts as income, regardless of what you do with the money.

This effect is also true for Health Savings Accounts (HSA) and Flexible Savings Accounts (FSA) contributions. On the FAFSA, HSA contributions are added back. On the CSS Profile, both HSA and FSA contributions are added back.

Second, it is common for small business owners and self-employed to reduce the amount of net income (or even showing a small loss) for tax savings purposes through depreciation and other expenses. This may not help.

For colleges using only the FAFSA, which is the majority of colleges and universities, business losses are reported as is. Before you go reducing your income to near zero, there’s a catch. If a non-business owner or self-employed family has an Adjusted Gross Income of $50k or less, they qualify for a simplified EFC calculation. Primarily, this means that the family’s assets are excluded.

For a family that is self-employed or owns a small business that files a Form 1040, Schedule 1, this simplified EFC formula does not apply. A Schedule 1 would reflect self-employment income and income from a small business via Schedule C, business income via Form K-1 on a Schedule E, and rental real estate income on Schedule E.

Third, being a small business owner or self-employed is less friendly for schools using the CSS Profile form. Any business losses are added back as well as depreciation expense. For example, if one parent works a regular W-2 job earning $100k and the other parent is self-employed and reports a tax loss of $100k per year, the tax return would show a zero net income ($100k in income less $100k in loss). For the CSS, that family would have an income of $200k.

The CSS Profile form has other requirements for business owner families, such as reporting the value of the business as well as submitting business tax returns, if filed separately.

In case you’re wondering, the schools that use the CSS Profile form are the Ivy League, near-Ivy League, as well as public Ivy schools, such as the University of Michigan, Univ of Virginia, Univ of North Carolina Chapel Hill, and UMiami.

Bonus item: One other difference between the two forms, though not tax-related, is the reporting of business bank accounts. On the FAFSA, any bank accounts in the name of the business are not reportable. On the CSS, the bank accounts are reportable. Again, the higher the assets, the less aid a family is likely to get.

Despite the differences, there are advantages that business owners and self-employed enjoy when saving and paying for college; I wrote a prior blog post on some strategies.

The bottom line is that while your CPA or tax professional may be well-intentioned and helpful for taxes, they may not help for financial aid and may raise the cost of college. Understanding these differences can help lead to smart decisions balancing tax savings and financial aid.

T. Jack Wang
Financial Wealth Strategist