Taxability of Employer-Provided Educational Assistance

Editor: Anthony S. Bakale, CPA, M. Tax.

Individuals

Generally, anything of value, including payments of tuition and other educational assistance, that an employer provides to an employee is treated as taxable compensation to the employee. However, there are at least four distinct circumstances in which employer-provided educational assistance is nontaxable. These sets of circumstances differ from each other significantly but can overlap. The purpose of this item is to provide a brief overview of them.

Job-Related Education as a Working Condition Fringe Benefit

Sec. 132(a)(3) allows an employee to exclude working condition fringe benefits from gross income. A working condition fringe benefit is defined in Sec. 132(d) as “any property or services provided to an employee of the employer to the extent that, if the employee paid for such property or services, such payment would be allowed as a deduction under section 162 or 167.”

Under Regs. Sec. 1.162-5, education expenses are deductible as ordinary and necessary business expenses if the education:

1. Maintains or improves skills required by the individual in his employment, or
2. Meets the express requirements of the individual’s employer, or the requirements of applicable law or regulations, imposed as a condition to the individual’s retaining an established employment relationship, status, or rate of compensation.

However, education expenses are not deductible under either of the following circumstances:

1. They are required in order to meet the minimum educational requirements for qualification in the employee’s employment or other trade or business; or
2. They are part of a program of study that will lead to the employees’ qualifying for a new trade or business.

Regs. Sec. 1.162-5 has been in effect in substantially its current form since 1967, and there have been hundreds of cases and rulings on such issues as whether the education:

1. Is sufficiently directly connected with the student’s current trade or business;
2. Qualifies the student for a new trade or business; or
3. Meets the criteria for being “ordinary and necessary,” which includes a reasonableness requirement and a requirement that the expenditures not be lavish or extravagant.

These determinations are very fact-specific, and there are many instances where good arguments can be made on both sides of the question of whether the education meets the criteria. However, in other instances, the issue is well-settled. For example, it is clear that regardless of the student’s intent, education leading to a juris doctorate law degree is not deductible because it qualifies the student for a new trade or business. (For more on this topic, see Medina and LaGarde, “Deducting Employee MBA Expenses,” 43 The Tax Adviser 454 (July 2012).)

If the education meets the criteria of Regs. Sec. 1.162-5, the employer’s payment or reimbursement for the education expenses under an accountable plan will not result in taxable income to the employee. In many, if not most, cases, it is clear whether the criteria are met. However, because the issue is so fact-specific, employers and their advisers need to address each situation separately and in some cases look at the case law and rulings to make a reasoned determination of whether a particular education program qualifies under these rules.

Education Provided Under a Sec. 127 Educational-Assistance Program

Under Sec. 127, up to $5,250 of educational assistance can be excluded annually from an employee’s income under a program that meets the following criteria, among others:

1. The program is a separate written plan for the exclusive benefit of employees;
2. Eligibility for the program does not discriminate in favor of highly compensated employees, as defined in Sec. 414(q), or their dependents;
3. Employees are not given a choice between benefits under the program or taxable compensation (typically cash); and
4. The education does not involve sports, games, or hobbies, unless such education is required as part of a degree program.

The following types of restrictive provisions are acceptable in Sec. 127 educational-assistance programs:

1. Job relationship requirements;
2. Limitations regarding when (e.g., during or after business hours) and where the courses can be taken;
3. Preapproval by, e.g., the program manager or the employee’s supervisor;
4. Proof of completion of the course;
5. Attainment of a minimum course grade; and
6. Completion of a certain period of employment (e.g., one year) after completion of the course.

Permissible benefits include tuition, fees, books, and supplies, but not (1) travel expenses or (2) tools or supplies (other than textbooks) that the employee can retain after completion of the course.

Sec. 127 has been in effect since 1978. It initially was scheduled to expire at the end of 1983 and has been temporarily extended numerous times since then. Most recently, Congress extended it as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), P.L. 107-16. EGTRRA is currently scheduled to expire on Dec. 31, 2012. Thus, although it seems unlikely that Congress will not re-extend Sec. 127 beyond 2012, it currently is scheduled to expire at the end of this year.

Qualified Tuition Reduction Programs of Educational Institutions

Sec. 117(d) provides a potentially very significant benefit to employees of educational institutions and their family members by excluding “qualified tuition reductions” from the employee’s taxable income. A “qualified tuition reduction” is a reduction in tuition at an educational institution, at or below the college undergraduate level, regardless of whether the institution is the employee’s employer. The exclusion can cover the employee, his or her spouse, or his or her dependent child.

The employer must administer the program so that it does not discriminate in favor of highly compensated employees, as defined in Sec. 414(q).

Sec. 117 defines an “educational institution” as an institution described in Sec. 170(b)(1)(A)(ii). Letter rulings have extended the exclusion to public colleges and to unincorporated schools operated by larger institutions such as a diocese.

Scholarship Programs Under Employer-Related Private Foundations

Sec. 117(a) excludes “qualified scholarships” from taxable income. In the context of an employer-employee relationship, the question of whether a grant qualifies under Sec. 117(a) essentially depends on whether the grant is, in fact, a payment for services.

Under Rev. Proc. 76-47, there are special rules addressing scholarship grants provided by employer-related private foundations to employees and their dependents. As is the case for all scholarship grants from private foundations, the grants must be awarded on an objective and nondiscriminatory basis under procedures that are preapproved by the IRS. Rev. Proc. 76-47 adds the following requirements, among others, for employer-related foundations:

1. Selection of the grant recipients must be made by a committee of individuals who are totally independent from the private foundation and the employer.
2. A grant may not be terminated, and renewal of a grant cannot be denied, because the recipient or the recipient’s parent terminated employment with the employer. Thus, employment with the employer cannot have any significance to eligibility, beyond being an initial qualifier.
3. The courses of study for which grants are available must not be limited to those that would be of particular benefit to the employer or the foundation.
4. If an employee must have been employed for a minimum period of time as a condition for grant eligibility, the period cannot exceed three years.
5. Grants cannot be made available to too large a percentage of employees or employees’ children who might be eligible for them. With respect to this requirement, there are certain safe-harbor percentages. If these safe harbors are not met, then all facts and circumstances must be reviewed to determine whether the primary purpose of the program is to educate the recipients, as opposed to providing extra compensation or another employment incentive.

Conclusion

The above discussion provides an overview of the circumstances under which an employer might provide educational assistance to employees in a manner that does not give rise to taxable income.

The two sets of rules that are most likely to be potentially applicable to most employers are the working condition fringe benefit rules and the Sec. 127 educational assistance rules. In many situations, educational assistance will clearly be excludable under Secs. 132 and 162 as a working condition fringe benefit. However, some employers may provide a significant amount of assistance that might not qualify under these rules. Undergraduate tuition assistance, for example, may be ineligible for exclusion if the education qualifies the student for a new trade or business. For these employers, it would make sense to consider implementing a Sec. 127 program to reduce uncertainty and to maximize the number of instances in which the employer can provide educational assistance on a tax-free basis.

EditorNotes

Anthony Bakale is with Cohen & Co., Ltd., Baker Tilly International, Cleveland.

For additional information about these items, contact Mr. Bakale at 216-579-1040 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly International.