Journal of Financial Planning: March 2017
Julie A. Welch, CPA, PFP, CFP®, is the director of tax services and a shareholder with Meara Welch Browne P.C. in Leawood, Kansas.
Cara Smith, CPA, CFP®, is a senior tax manager with Meara Welch Browne P.C. in Leawood, Kansas.
The internal revenue Code provides tax incentives to help offset the costs of higher education in a variety of forms such as above-the-line deductions for tuition and fees and student loan interest, the American opportunity tax credit, the lifetime learning credit, and college savings plans such as 529 plans. Perhaps you are pursuing a graduate degree or have clients who are doing the same. If that’s the case, what benefits are available for working adults who go back to school to get a master’s degree?
Tax-Free Benefits
Having an employer sponsor or pay for business-related courses is the best option for an employee, because those benefits can often be structured so they are tax free to the employee.
A tax-free benefit can be attained in one of two ways: (1) through an employer-provided educational assistance plan; or (2) if the education courses are business related and a condition of employment. Employer-provided educational assistance plans are written plans established by the employer that can provide up to $5,250 of benefits to each employee annually. These plans are not limited to work-related courses; they can include most undergraduate or graduate-level courses that are required as part of a degree program or have a reasonable relationship to the business of your employer.
Absent an employer-provided educational assistance plan, an employer can provide and/or pay for educational courses that are business related. Employers in certain industries and professions can require their employees to attend a certain amount of training or specific course-related education each year. For example, licensed CPAs, attorneys, and doctors must obtain a required number of education hours on an annual basis to maintain certification. If your firm or your clients’ employer pays for such expenses, that’s great—this column isn’t for you. If not, keep reading. Beyond getting scholarships and/or grants, there may still be availability for a business deduction for the costs of education, even higher-education costs that result in college credit and/or a degree.
Business Deduction for Work-Related Education
Similar to work-related deductions such as business auto mileage and supplies, work-related education expenses are also allowable deductions. Employees can deduct work-related education expenses as miscellaneous itemized deductions, which when added to all other miscellaneous itemized deductions, are subject to the 2 percent of adjusted gross income (AGI) and alternative minimum tax limitations. An employee must itemize deductions and have expenses in excess of 2 percent of AGI to take the tax deduction. Self-employed persons, like those who report income on a Schedule C, get a better result because they can deduct work-related education expenses against gross income in arriving at net taxable profit. Expenses that can be deducted include tuition, books and fees, and related expenses, as well as certain transportation and travel costs.
To qualify as work-related business education expenses, amounts must be: required by your employer or by the law to keep your present job or salary; and/or expenses for education that maintain or improve skills needed for your current position.
However, if the education is necessary to meet the minimum requirements for your current job, or if the education qualifies you for a new professional trade or business, the expenses are not qualifying work-related business expenses, and therefore, not deductible as work-related education expenses. The criteria related to qualifying for a new trade or business is an important one outlined in the Treasury Regulations. Section 1.162-5(b)(1) provides an example:
“A, a self-employed individual practicing a profession other than law, for example, engineering, accounting, etc., attends law school at night and after completing his law school studies receives a bachelor of laws degree. The expenditures made by A in attending law school are nondeductible because this course of study qualifies him for a new trade or business.”
In 2016 the Tax Court ruled on several cases involving deducting business-related education expenses. One case, dealing with law school tuition, was unfavorable for the taxpayer but it had somewhat expected results. The other case, dealing with an executive MBA program, resulted in a taxpayer friendly outcome.
The first case, Santos V. Commissioner (T.C. Memo 2016-100), dealt with costs associated with attending law school. Although in direct contradiction to the Treasury Regulations, Emmanuel Santos deducted $20,275 of law school tuition. When questioned by the IRS, Santos challenged the validity of the regulations that disallow education costs that qualify a taxpayer for a new trade or business—specifically a law degree. Santos was a tax preparer and enrolled agent who had a bachelor’s degree in accounting. He later began taking law school classes and in 2011 he deducted his tuition and fees as a business deduction. As expected, the Tax Court rejected Santo’s challenge and held the law school-related expenses were not deductible as the courses would lead to qualifying him for a new trade or business. In fact, after graduating from law school and passing the bar exam, Santos and his father started a law firm providing services in legal representation, tax planning, accounting, and financial planning. One takeaway from this case is that challenging the validity of a regulation does not often result in a favorable tax result.
Another business-related education expense case in 2016 resulted in a big win for students. Alex Kopaigora was a senior assistant controller employed by Marriott International Corp. in Los Angeles, California. In 2010 he enrolled in an executive MBA (EMBA) program at Brigham Young University, and he commuted to Salt Lake City, Utah, every other weekend for classes. In 2011, Kopaigora was terminated from his job at Marriott, however, he continued working on his EMBA while looking for other work. On their 2011 income tax return, Kopaigora and his wife deducted more than $18,000 of education-related business expenses for tuition, commuting, and fees.
Kopaigora argued that the expenses were deductible, unreimbursed business expenses as he was already established in the corporate finance and management field before he started taking courses for his EMBA. The degree did not qualify him for a new trade or business. Due to the termination and resulting unemployment, the IRS argued that Kopaigora did not carry on a trade or business throughout the entire 2011 tax year. After receiving his EMBA in August 2012, Kopaigora was hired as a vice president of finance at a small finance-related company. Additionally, the IRS argued that the EMBA qualified Kopaigora for a new trade or position and that the EMBA was a general degree that did not maintain or improve specific skills required for his employment.
The Tax Court disagreed and held in favor of Kopaigora ruling that he was well-established as a finance and accounting manager, that the courses were appropriate and helpful to his position as a business manager, and that the executive MBA did not qualify him for a new trade or business.
This case is a big win for MBA students, especially those in between jobs who start the program while still employed. The deductions were allowed even though the taxpayer was unemployed for a substantial portion of 2011 while he was taking EMBA courses and pursuing his degree. The IRS has often argued that a taxpayer pursing an MBA who has not been working for two years is not carrying on a trade or business, hence no employee business expense deduction would be allowed. The courts on the other hand, have often accepted the argument that business school is just temporary, ending with the student returning to his or her previous trade or business after attaining a degree.
The other important aspect of this case is that it confirms that an executive MBA does not qualify the taxpayer for a new trade or business like a degree in law or medicine or even an undergraduate degree. Many MBA and graduate students have jobs before enrolling in the MBA program and are only seeking to improve or maintain their skills—and not seeking qualifications for a new job. However, be wary; immediately changing jobs and entering a new industry upon completion of an MBA is still likely to disqualify a taxpayer from the deduction.
Other Education-Related Tax Incentives
The lifetime learning credit and the above-the-line deduction for tuition and fees are also available for professionals with business-related education expenses. However, they start to phase out for those with incomes over certain amounts. A credit reduces the amount of tax you owe, and a deduction reduces the amount of income subject to tax. Thus, a credit is generally better than a deduction because it directly reduces the amount of tax you ultimately owe.
Tuition and fees deduction. Up to $4,000 per return can be deducted as an above-the-line deduction from AGI for qualified higher-education costs. This deduction is available whether a taxpayer itemizes deductions. However, the deduction is only available for taxpayers with AGIs under $80,000 ($160,000 if filing a joint return). Unless there is legislation, 2016 may have been the last year for this deduction.
Lifetime learning tax credits. The lifetime learning tax credit can provide up to a $2,000 credit per return for those with incomes under a maximum of $65,000 ($130,000 if filing a joint return). Unless subject to phase out rules on income, the credit is typically 20 percent of qualifying education expenses.
Student loan interest deduction. Interest up to $2,500 paid on student loans can be deductible as an above-the-line deduction. The availability of the student loan interest deduction is limited to those with incomes up to $80,000 ($160,000 if filing a joint return).
The fact that there are many tax incentives available to help offset the cost of business-related education is good news for taxpayers. Because the various incentives have different requirements and rules, each situation must be analyzed to see which option works best for the individual taxpayer.