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Small Business Exclusion

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Since July 1, 2006, small businesses that are owned and controlled by the family are excluded as assets on the Free Application for Federal Student Aid (FAFSA). The impact of this change is discussed below, including the legislative basis, criteria for exclusion, other exclusions, special rules for business or farm debt, and the relevance to rental properties.

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Legislative Basis

The small business exclusion was established by section 8019(c) of the Higher Education Reconciliation Act of 2005 (HERA 2005) as part of the Deficit Reduction Act of 2005 (P.L. 109-171, February 8, 2006). The specific amendment is as follows:

(c) TREATMENT OF FAMILY OWNERSHIP OF SMALL BUSINESSES. -- Section 480(f)(2) (20 U.S.C. 1087vv(f)(2)) is amended --

  1. in subparagraph (A), by striking "or";

  2. in subparagraph (B), by striking the period at the end and inserting "; or"; and

  3. by adding at the end the following new subparagraph:

    "(C) a small business with not more than 100 full-time or full-time equivalent employees (or any part of such a small business) that is owned and controlled by the family.".

After this amendment is applied to section 480(f)(2) of the Higher Education Act of 1965, the legislative language becomes:

With respect to determinations of need under this title, other than for subpart 4 of part A, the term "assets" shall not include the net value of --

  1. the family's principal place of residence; or

  2. a family farm on which the family resides.

  3. a small business with not more than 100 full-time or full-time equivalent employees (or any part of such a small business) that is owned and controlled by the family.

The purpose of the amendment in sheltering a family's livelihood is highlighted in the following paragraph from the Report on the legislation from the House Committee on the Budget (emphasis added):

During the 1992 reauthorization of the Higher Education Act, the bill passed by the House of Representatives included a provision that exempted small business assets from need analysis formula. During the consideration of H.R. 609, Representative Marilyn Musgrave (R-CO) offered, and the Committee accepted, a similar amendment that exempted small business assets from the need analysis formula for families that own a business that employs less than 100 full-time equivalent employees. Under current law, farm equipment and other assets attributed to farms are excluded from the need analysis formula. The Committee believes this same protection should apply to small business owners, who should not be asked to borrow against their way of living to finance a child's education and the modification is included in the Committee Print.

The US Department of Education provided subregulatory guidance concerning the small business exclusion on page AVG-17 of the 2009-10 Application and Verification Guide:

Family-owned and controlled small businesses (which can include farms) that have 100 or fewer full-time or full-time equivalent employees do not count as an asset. "Family-owned and controlled" means that more than 50% of the business is owned by persons who are directly related or are or were related by marriage (family members do not have to be counted in the household size for this question).

Criteria for Exclusion

The small business exclusion establishes the following criteria for a small business to be excluded from assets on the FAFSA:

If the small business is a partnership where each partner owns exactly half of the business, and the family is one partner and a third party is the other, it does not qualify for the small business exclusion. In order to qualify, the family must own a majority of the business (more than half). Otherwise, the family does not control the business and must report it on the FAFSA as either a business asset or an investment. If they own 51% it is excluded; if they own 50% it is not excluded.

The US Department of Education issued subregulatory guidance that uses a laxer definition of "family" than appears in section 481(l) of the Higher Education Act. The US Department of Education guidance indicates that for the purpose of the small business exclusion, family is not restricted to individuals counted in household size on the FAFSA. It can include family members who are directly related by birth or marriage to the people counted in household size. This includes siblings, parents, grandparents and spouses.

Note that if the family owns two small businesses, each with 100 or fewer FTE employees, but which together have more than 100 FTE employees, each business may nevertheless qualify for exclusion.

If a FAFSA is selected for verification, the college may ask for a copy of Schedule C or IRS Form 1120. While these forms do not list the number of employees, they do list the total amount paid as salaries. College financial aid administrators will use a rule of thumb to estimate the number of employees, by dividing the total salary by $10,000. If the result is more than 100, they may ask for documentation concerning the number of employees.

A business does not need to be incorporated to be considered a small business. Sole proprietorships and partnerships can also be considered a small business. Likewise, the type of tax return filed (Schedule C, Schedule C-EZ, IRS Form 1120) does not affect whether the business can be excluded.

The small business exclusion only excludes the reporting of the business as an asset on the FAFSA. If the business is a pass-through entity (e.g., sole proprietorship, partnership, S corporation or LLC), the business income attributable to the taxpayer (e.g., through schedule C or schedule K-1) must still be reported on the FAFSA. Likewise, any salaries paid by the business to the family still count as income. Generally, this income will be included in adjusted gross income (AGI) and should match the figure reported on the FAFSA.

Rental Property

Occasionally a family will try to characterize a rental property as a small business in order to have it excluded as an asset on the FAFSA. For example, the family might own a vacation home which they rent when they aren't using it themselves.

This situation is addressed in a margin note on page AVG-19 of the 2006-2007 Application and Verification Guide:

At times a student or parent will claim rental property is a business. Generally, it must be reported as real estate instead. A rental property would have to be part of a formally recognized business to be reported as such, and it usually would provide additional services like regular cleaning, linen, or maid service.

This note mirrors the language from "How To Report Rental Income and Expenses" on page 16 of IRS Publication 527, Residential Rental Property (Including Rental of Vacation Homes). This section of Publication 527 discusses whether rental income is reported on Schedule E or on Schedule C or Schedule C-EZ of IRS Form 1040. In order to file Schedule C or Schedule C-EZ, the taxpayer must "provide significant services that are primarily for your tenant's convenience, such as regular cleaning, changing linen, or maid service". It continues "Significant services do not include the furnishing of heat and light, cleaning of public areas, trash collection, etc.".

Note that the verification guide is not merely saying that the type of schedule filed indicates whether the rental property is a business asset or not, but rather referring to the same underlying criteria. So while Schedule C or Schedule C-EZ can be an indication of a business, college financial aid administrators will examine the schedule looking for signs of "significant services" besides basic utilities. They may also want to see evidence that the family is treating it as a business, such as registration with the local municipality and the state, an employer identification number (EIN), a fictitious name registration, a separate business checking account and so on. It is not just which schedule was filed, but whether the taxpayer was entitled to file that schedule.

On the other hand, if the rental income is reported on Schedule E, it is always reported as an investment asset on the FAFSA. Personal use of the rental property (e.g., as a vacation home) or minimal rental use would also tend to indicate that the rental property is not a business asset.

If the family owns multiple rental properties and materially participates in the management of the properties, they are more likely to be considered business assets.

Page 21 of IRS Publication 334 elaborates on the criteria for filing Schedule C, indicating that Schedule C is reserved for real businesses and not casual rental income:

If you are a real estate dealer who receives income from renting real property or an owner of a hotel, motel, etc., who provides services (maid services, etc.) for guests, report the rental income and expenses on Schedule C or C-EZ. If you are not a real estate dealer or the kind of owner described in the preceding sentence, report the rental income and expenses on Schedule E.

Real estate dealer. You are a real estate dealer if you are engaged in the business of selling real estate to customers with the purpose of making a profit from those sales. Rent you receive from real estate held for sale to customers is subject to SE tax. However, rent you receive from real estate held for speculation or investment is not subject to SE tax.
...
Hotels, boarding houses, and apartments. Rental income you receive for the use or occupancy of hotels, boarding houses, or apartment houses is subject to SE tax if you provide services for the occupants. Generally, you are considered to provide services for the occupants if the services are primarily for their convenience and are not services normally provided with the rental of rooms for occupancy only. An example of a service that is not normally provided for the convenience of the occupants is maid service. However, providing heat and light, cleaning stairways and lobbies, and collecting trash are services normally provided for the occupants' convenience.

The IRS treats rental activities as passive activities even if the taxpayer materially participated in the activity, unless the taxpayer is a real estate professional. The term "real estate professional" is defined on page 15 of IRS Publication 527 as:

Real estate professional. You qualified as a real estate professional for the tax year if you met both of the following requirements.

  1. More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.

  2. You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.

Do not count personal services you performed as an employee in real property trades or businesses unless you were a 5% owner of your employer. You were a 5% owner if you owned (or are considered to have owned) more than 5% of your employer's outstanding stock, or capital or profits interest.

If you file a joint return, do not count your spouse's personal services to determine whether you met the preceding requirements. However, you can count your spouse's participation in an activity in determining if you materially participated.

Real property trades or businesses. A real property trade or business is a trade or business that does any of the following with real property.

  • Develops or redevelops it.
  • Constructs or reconstructs it.
  • Acquires it.
  • Converts it.
  • Rents or leases it.
  • Operates or manages it.
  • Brokers it.

Material participation. Generally, you materially participated in an activity for the tax year if were involved in its operations on a regular, continuous, and substantial basis during the year. For more information, see Publication 925.

If the business is incorporated (e.g., C corporation, S corporation, LLC), the "significant services" requirement does not generally apply. Incorporating the business avoids many questions about whether it really is a business or not. However, the rental property must be owned by the business in order to be excluded, as the small business exclusion only applies to the business and its assets. The small business exclusion does not apply to assets that are managed by the business but not otherwise owned by the business. If the deed to the property is in the family's name, it is a personal asset and must be reported as an investment asset on the FAFSA. If the deed is in the name of the business, then it can be excluded on the FAFSA if the small business exclusion applies. For example, if the family owns a property which it rents to the business, that property is reported as an investment asset on the FAFSA because it is owned by the family, not the business.

See also Rental Property and Multi-Family Residences.

Other Exclusions

Section 480(f)(2) of the Higher Education Act also includes exclusions for the family's principal place of residence and a family farm on which the family resides. The principal place of residence and a family farm are excluded, even if they are part of the family business. This provides another opportunity for family businesses to be excluded.

A margin note on page AVG-19 of the 2006-2007 Application and Verification Guide provides guidance as to what is considered a family farm:

Family farm

A farm (including equipment, livestock, etc.) isn't reported as an investment on the FAFSA if:

  • it is the principal place of residence for the applicant and the applicant's family, and
  • the applicant (or parents of a dependent applicant) materially participated in the farming operation

Material participation is generally interepreted as meaning that more than half of the family's income is produced by the farming operation. However, unlike the small business exclusion, the family farm does not need to be controlled by the family in order for the portion owned by the family to be excluded.

A family farm that satisfies these requirements is excludable even if it is owned by a business such as a sole proprietorship, family partnership or S corporation.

Income from a family farm may be reported on Schedule F if the farm is not incorporated.

Business or Farm Debt

If a business or farm does not qualify for one of these exclusions, the net worth is reported as an asset on the FAFSA. There is a separate question for such businesses and investment farms, as the net worth is adjusted to shelter part of the value of the asset.

The net worth is calculated by subtracting business or farm debt from the current fair market value of the business or farm (including the value of land, buildings, inventory, equipment, machinery and livestock). To be considered a business or farm debt, the debt must be secured by the business or farm. If the debt uses something else as collateral, it does not offset the value of the business or farm.

For example, if the family used a home equity loan to capitalize the business, the balance on the loan may not be used to reduce the fair market value when computing the net worth, as the loan is secured by the home, not the business. The family could ask the college financial aid administrator to use "professional judgment" to allow the home equity loan to offset the business value. However, most colleges will not allow such an adjustment because the debt was not restricted to use for the business. Also, the value of the family's principal place of residence is excluded on the FAFSA, making it difficult to justify allowing a debt against the home to offset other assets.

See FinAid's Federal Housing Index Calculator for a tool for estimating a minimal fair market value. College financial aid administrators may also ask for copies of any recent appraisals or tax assessments when evaluating the value of the asset. They will also spot check the value by using tools like HomeRadar, Zillow, Eppraisal and Domania that provide ballpark estimates for a home's worth and by using local real estate property listings. They will also use other leading real estate web sites like Cyberhomes, Trulia and Realtor.com.

 

 
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