Educational expense deductions: the maze of tests.by Daughtrey, Zoel W.
In today's business and professional environment, many taxpayers seek further education to increase their employment skills. The reference to check whether related educational expenditures qualify as a federal income tax deduction, is Reg. Sec. 1.162-5. To qualify, the expenditures must first meet the trade or business expense requirements of Sec. 162. If so, the expenditure is tested against two "disqualifying" tests which prohibit the deduction where the education either:
1. Meets the minimum requirement of the taxpayer's present trade or business; or
2. Qualifies the taxpayer for a new trade or business.
If the education survives the disqualifying tests and meets the Sec. 162 requirements, the next step is to meet one of the qualifying" tests. Expenditures will pass the qualifying tests if incurred either:
1. To meet express legal or employer-imposed requirements for the taxpayer to retain employment status or rate of compensation; or
2. To maintain or improve skills required in the taxpayer's trade or business.
Trade or Business Expense
Educational expenditures will be considered a Sec. 162 trade or business expense if they are ordinary and necessary in carrying on a trade or business. The two key tests under Sec. 162 are: 1) whether the taxpayer actually has a trade or business when the expenditure is incurred, and 2) whether the expenditure bears a direct and proximate relationship to that trade or business. Trade or Business
A taxpayer must have a trade or business (including that of an employee) at the time of the expenditure. Expenditures incurred during temporary leaves of absence from a trade or business may, nevertheless, qualify. As to the meaning of the term temporary," disagreement often arises between the IRS and the Tax Court.
TAX PLANNING FACTOR 1. When leaves of absence are longer than one year, the taxpayer should carefully document the previous experience in the particular trade or business and the intent to return thereto after the education.
LTR 8538068 involved a taxpayer who held a position in marketing/general management and requested a leave of absence to further his education. The request was denied and the taxpayer resigned to pursue an MBA degree. The taxpayer was away from any trade or business for two years. Upon finishing the program, he accepted a position in the field of marketing, assuming responsibilities similar to those of his previous job. In the ruling, the IRS relied upon Rev. Ruls. 60-97 and 68-591, which state that a leave of absence less than or equal to one year will be considered temporary Because the taxpayer had been away from business more than one year, the IRS denied the deduction.
Although the Service maintained this position in Sherman, the Tax Court rejected the one year limitation, stating, ...a revenue ruling is no more than the opinion of one of the litigants in the case." The rationale behind the court's position was that the leave of absence was not for "an indefinite period of time."
TAX PLANNING FACTOR 2. if a timely return to suitable employment is not possible, because of lack of opportunities, the taxpayer should at least demonstrate an attempt to do so.
In Picknally, the Tax Court continued its rejection of the one year limitation stating that it does not "recognize such an absolute time limitation." Each case must be decided on its own facts. The court noted that a taxpayer can still be engaged in a trade or business, although currently unemployed, if previously so engaged in and intending to return thereto.
Picknally had worked in the field of education for about 10 years prior to entering a PhD program in educational administration. Upon completion of a three-year PhD program, he made persistent attempts to re-enter the profession by sending letters of application to institutions and maintaining his record on file at two different colleges. The Tax Court deemed his leave of absence to be temporary, noting:
1. Picknally's prior work record;
2. The obvious intent to return to the field of education, exemplified by active search for a position; and
3. The period of study was not of an indefinite duration.
TAX PLANNING FACTOR 3. The taxpayer's prior work record plays a vital role in determining whether he/she is actively engaged in the trade or business when the education is pursued.
One final issue, which arose in Link, concerns the time required to be considered actively engaged in a trade or business. Link received an undergraduate degree in May 1985 and immediately began work. After that summer, Link resigned from his position to pursue an MBA. Subsequently, Link deducted the costs of his continued education, asserting that he had a trade or business and was merely taking a temporary leave of absence. The Tax Court disagreed, claiming that there must be a measure of permanence to one's activities before they constitute a trade or business. One factor cited by the court was that Link had applied to and been accepted into the MBA program before his employment began and his Form W-4 indicated exemption from withholding-implying a student status. Nevertheless, the Tax Court avoided setting forth the exact time required to be considered actively engaged in a trade or business. once the taxpayer demonstrates that the trade or business existed at the time of the expenditure, the next step is to establish a direct and proximate relationship between the education and the trade or business.
Direct and Proximate Relationship
The direct and proximate test was defined by the Tax Court in Cohn. in this case, the taxpayer was a physical education instructor who took lessons in handball and racquetball to improve required teaching skills. The Tax Court allowed the deduction, stating that;
"A precise correlation is not necessary, and the education expense need not be for training which is identical to the taxpayer's prior training, so long as the education enhances the taxpayer's existing skills."
An educational expense does not necessarily have to be associated with a formal or conventional training program. McCulloch was an elementary school teacher who spent a sabbatical in ireland to learn the art of storytelling. She did not attend any classes, but rather conducted an independent library and field study. She maintained a regular schedule of study and investigation while in Ireland.
McCulloch was able to demonstrate the professional benefit of the sabbatical research in improving teaching skills and the ability to effectively advance the education of elementary school children through the art of storytelling. Because she was able to demonstrate that the sabbatical was primarily business-related, and that it did bear a direct and proximate relationship to the skills required in her teaching position, she was allowed to deduct expenses for food, lodging, transportation and travel.
Thus, it could be concluded that virtually any education which improves one's skills required in an existing trade or business may qualify for deduction. However, the failure to establish such a relationship can well result in a nondeductible expenditure.
Takahashi was a high school science teacher who taught classes composed largely of minority students, predominately Hispanic. He attended a seminar in Hawaii entitled "The Hawaiian Cultural Transition in a Diverse Society" and asserted that he attended the seminar to better understand and communicate with his students and thus to improve skills used in his trade or business. However, the Tax Court concluded that the seminar provided the teacher with general cultural enrichment rather than the specific qualities needed to teach science. Therefore, the expenditures were not deductible because Takahashi failed to establish the direct and proximate relationship. While it may often be difficult to meet the trade or business requirements of Sec. 162, the majority of disallowed educational expenses are a result of the disqualifying tests.
Minimum Educational Requirements
Regardless of the taxpayer's employment status at the time of the educational expenditure, education which meets the minimum requirements to attain employment as defined by relevant law, a specific employer, or the standards of the profession is disqualified.
TAX PLANNING FACTOR 4. The taxpayer should be cognizant of the minimum educational requirements for the trade or business by referring to job specifications, relevant laws and/or regulations, or by consulting knowledgeable members of the profession, as most applicable.
In Davidson, the Tax Court disallowed the deduction for educational expenditures of an accountant employed by a corporation which had job specifications requiring a college degree or its equivalent. Davidson was employed before obtaining his college degree and was allowed to pursue the required degree while working. Thus, the deduction was disallowed because the taxpayer was attending classes to meet the minimum educational requirements of the specific employer.
Qualifying for a New Trade or Business
In a variety of situations, taxpayers attend different types of courses and pursue different programs of study, generally claiming that the purpose of the education is to improve skills in a present trade or business or to meet the employer's requirements. Although some cases involve taxpayers qualifying for a new trade or business, the taxpayer will assert there is no intention of pursuing the new trade or business. Regardless of purpose or intentions, education which may lead to qualifying, or does qualify, an individual for a new trade or business results in a nondeductible expenditure.
TAX PLANNING FACTOR 5. Since many trades or businesses either do not have specific minimum educational requirements or have very strict requirements, the majority of disallowed deductions are a result of the qualifying for a new trade or business" test.
Burton was employed as a supervisor of a hospital laboratory supply company and was required to make decisions which could affect company liability. He was encouraged to further his education by attending law courses at the employer's expense. He attended courses which were part of a university's juris Doctor degree program, but asserted that he pursued the education only to improve his decision-making skills. Although the Tax Court agreed that the courses would improve these skills the deduction was disallowed because the program of study could lead to the taxpayer's qualification for practicing law.
Cooper was a practicing accountant who attended economics, finance, mathematics, and accounting courses to improve his skills in public accounting. Although Cooper did not have a CPA license, he was engaged in an active accounting practice. The court concluded that all the courses improved skills required in public accounting, but allowed only a proportionate deduction. The accounting course (no deduction allowed) would contribute to Cooper's qualifying to take the CPA examination and could qualify Cooper for a new trade or business. The court distinguished the business of public accounting from the business of being a CPA because a CPA can certify sic financial statements.
Schwernn was a part-time group discussion leader at a technical college and held a BA in Education and Sociology,. While working as a discussion leader, which had no minimum educational requirements, she pursued an MS degree in Educational Psychology to improve her skills. Upon obtaining that degree, Schwernn would be qualified to become a school guidance counselor. Therefore, the IRS claimed that the education would qualify her for a new trade or business. However, the court concluded that the business of being a group discussion leader was very similar to that of being a guidance counselor and allowed the deduction, citing the Treasury Regs. which state, "...all teaching and related duties shall be considered to involve the same general type of work." The Tax Court went on to define when education actually qualifies an individual for a new trade or business, stating;
". . if the education provides the individual with the ability to perform significantly different tasks and activities than the individual could perform prior to the education, then it will be considered to have qualified the individual for a new trade or business."
This description is what the Tax Court considers to be an objective "common sense approach" to determining whether the taxpayer indeed qualifies for a new trade or business
TAX PLANNING FACTOR 6. Specialties and new positions are not considered a new trade or business. However, the taxpayer has the burden of proving that the new position or area of specialty involves the "same general type of work," which is a difficult task. Thus, when dealing with professions other than teaching, advisers should exercise caution in concluding that any taxpayer is not qualifying for a new trade or business when the new duties involve even a minor change.
Walker was an attorney and a member of the New Jersey and Pennsylvania bars who decided to expand her law practice to include California. She subsequently deducted the costs of a California bar review course and the bar examination fees as educational expenses. Although the court agreed that the taxpayer was expanding her law practice, it disallowed the deduction claiming that she was doing so by qualifying for a new trade or business, that of practicing law in California.
In contrast with other professions, the teaching profession is allowed special treatment, as is evidenced by Rev. Rul. 71-58 and Laurano. Laurano was a teacher from Canada who moved to the U.S. and took courses to qualify for a position in New jersey. She was allowed to deduct the costs of courses which so qualified her.
TAX PLANNING FACTOR 7. Although most professionals have been denied immediate educational deductions when qualifying for interstate expansion, the taxpayer should be aware that the IRS and the courts agree that amortization of the expenditures may be acceptable.
Although professions other than teaching have received unfavorable tax treatment with regard to new locations, concessions by both the Tax Court and the Service were evident in Walker. There it was concluded that although the expenditures were not immediately deductible, amortization over Walker's life expectancy was acceptable.
Once the educational expenditure survives the disqualifying tests, it must then be subjected to the qualifying tests to be allowed as a deduction.
Requirements to Retain Status in a Trade or Business
The first qualifying test under Reg. Sec. 1.162-5(c) is to determine whether the expenditure meets the requirements of the employer or relevant law for the employee to retain a certain status or rate of compensation. According to the regulation, this must be an express requirement. For example, a professional attending courses or seminars to satisfy the relevant continuing professional education requirements would meet this test. Any education in excess of the express requirements may qualify under the maintaining or improving skills test. Maintaining or Improving Skills
The test for determining whether education maintains or improves required skills is subjective and relies heavily on the taxpayer's ability to produce evidence establishing that the education did, in fact, maintain or improve these skills.
Many successful cases involve taxpayers producing expert testimony establishing the necessary relationship between the education and the trade or business, while others cite previous decisions involving taxpayers with similar circumstances which had favorable outcomes.
TAX PLANNING FACTOR 8. Expert testimony and/or legal precedence is an ideal method for establishing the "maintaining or improving skills" test.
Stoddard was a flight manager and was required to have a valid DC-9 pilot's license since, at certain times, emergencies could arise necessitating his piloting a DC-9. Stoddard purchased a private plane to maintain and improve his skills as a pilot and subsequently deducted the maintenance and operating costs as educational expenses. Expert testimony was produced confirming that to maintain proficiency as a DC-9 pilot, one should fly a similar plane a minimum of five to 10 hours per month. The expert stated that flying in excess of the minimum would, undoubtedly, improve one's skills in flying the DC-9. Relying heavily on the expert's testimony, the Tax Court concluded that piloting Stoddard's private plane with the seven basic flight instruments, which were also on the DC-9, did indeed maintain and improve the required skills. The allowed deduction included the costs of maintenance and operating the plane along with depreciation, state property taxes, and registration and licensing fees.
Porter was a practicing psychiatrist who deducted the costs of psychotherapy as educational expenses. Porter cited two similar cases involving taxpayers who were allowed to deduct the costs of psychoanalysis, because the psychoanalysis improved their skills as a psychiatrist and a social worker. Moreover, as additional evidence, Porter produced expert testimony which further confirmed that psychotherapy does improve the skills required of a psychiatrist. Porter kept detailed records including a diary, bills, receipt, and cancelled checks. Although he failed to completely substantiate the amounts claimed which totaled some $67,000 for two years, he produced evidence supporting approximately $41,000 thereof. This evidence contributed to the Tax Court's decision to allow the deduction to the extent substantiated.
Optimizing die Deduction
To optimize the deduction, one should be aware of all educational items which fall within the spectrum of trade or business expenses. Although the regulations allow a deduction for certain educational costs as business expenses, they do not define the term "educational." The IRS has defined educational expenses as "amounts spent for tuition, books, supplies, laboratory fees, and other similar items, and certain travel and transportation costs. Educational expenses also include the cost of correspondence courses, tutoring as well as formal training, and research and typing to prepare a paper as part of an educational program."
Travel Incident to Education
Although many education-related cases involve taxpayers who incur the expenses within the same general area as the tax home, a number of educational undertakings require travel. To determine whether these travel expenses qualify as trade or business expenses, the taxpayer should refer to Sec. 1.162-5(e), which, in effect, extends the general business travel rules to cover travel incident to education. The deductibility of these expenditures will be determined using the distinction between education-related travel that is "primarily personal" or education-related travel that is "primarily business." The key determining factor is the time spent on business or qualifying education, in contrast with the time spent on personal activities. For example, if a taxpayer traveled away from the tax home for two weeks to attend a three-day seminar, the deductions for travel would be limited to those expenses directly related to the business aspects of the trip. Thus, expenses for meals and lodging during only the time spent on educational activities would be deductible. The transportation expense would be personal. In contrast, if the taxpayer was away for only the three days required by the seminar, the taxpayer would be able to deduct virtually all expenses associated with the travel, still excluding personal expenditures.
Travel can itself be a form of education (for example, a European tour) or it can be undertaken primarily to obtain education (traveling to a university or seminar). For tax years beginning before january 1, 1987, expenses for travel as a form of education were deductible if other requirements were met. However, thereafter deductions may not be claimed for travel as a form of education.
TAX PLANNING FACTOR 9. The taxpayer should evaluate all expenses incurred in pursuing education as potentially qualifying educational expenses, unless they are obviously primarily personal in nature.
Identification of the types of education-related travel expenditures which qualify as trade or business expenses i's a necessity to optimize the deduction. A wide variety of items will qualify including:
* Meals and lodging (en route and at destination);
* Transportation costs (air, rail, or bus fares), costs of transporting bags, sample cases, operating and maintenance expenses of automobiles, house trailers and airplanes;
* Cleaning and laundry expenses;
* Telephone and telegraph costs; and
* Local transportation, commuting expenses (from airport or station to hotel, from one place of business to another, and other local transportation expenses such as from the place where meals and lodging are provided to a temporary work assignment).
Many educational endeavors require the taxpayer to leave the tax home for an extended time. For example, often taxpayers will temporarily relocate to attend an educational institution. As the duration for the absence from the tax home increases, the amount of the potential deduction also increases, but the likelihood that the taxpayer will be deemed to have relocated the tax home also greatly increases. A relocation deemed permanent will eliminate the possibility of deducting travel expenses. Thus, a critical factor is that the taxpayer has maintained the tax home in the original location and is merely relocating on a temporary basis.
TAX PLANNING FACTOR 10. The taxpayer should be aware that the courts consider even the smallest of factors in evaluating whether it is a temporary relocation, such as library cards, resident hunting licenses, etc.
Johnson, who had been a professor of nursing at the University of Texas for 17 years, decided to pursue a doctoral degree at the University of Hawaii. Because this relocation to Hawaii involved an extended time, it was important for johnson to establish that she had relocated on a temporary basis and had maintained her tax home in Texas. Although johnson had sold her Austin home prior to the relocation, Austin was still considered her tax home. in finding for the taxpayer, the Tax Court set forth the following reasons:
* Her stay in Hawaii was not indefinite; the doctoral program was of a specified duration;
* She returned to her teaching job in Austin after completing the doctoral program; and
* Other factors made it apparent that johnson had not abandoned her home in Austin, including:
1. she received a Texas guaranteed student loan,
2. she maintained a credit union account in Austin,
3. she paid Texas property taxes,
4. she paid nonresident tuition at the University of Hawaii,
5. she filed a nonresident state income tax return for Hawaii,
6. she stored personal belongings in Austin, and
7. she maintained Austin library cards.
Because johnson established that Austin remained her tax home and that her stay in Hawaii was only temporary, she was allowed to deduct her lodging expenses for the duration of her stay. Although johnson apparently made no attempt to deduct expenditures for meals and transportation, she may well have been allowed such deductions, because her stay in Hawaii was considered business travel involving a temporary relocation.
It is obvious that the types of expenses which qualify for the trade or business expense deduction are numerous. To optimize the deduction, the taxpayer should be aware that identification of qualifying expenses is of the utmost importance.
Integrating the Tests
From a broad perspective, educational expenditures are applied against a series of tests to determine deductibility.
Trade or Business Test and the "Qualifying" Tests
If an expenditure meets either of the qualifying tests, it will ordinarily meet the trade or business requirements of Sec. 162. For example, most education which maintains or improves a taxpayer's skills in a trade or business will obviously be directly related to that trade or business and thus will qualify under Sec. 162. Similarly, most education which qualifies under these direct and proximate relationship tests will be considered to maintain or improve skills required in the trade or business.
One exception is an expenditure that is considered unreasonable. For example, an expenditure for education may actually maintain and improve skills or meet express requirements, yet may lack sufficient merit to fall within the meaning of the ordinary requirement of Sec. 162 which permits all reasonable expenditures. However, Porter (the psychiatrist who deducted the costs of psychotherapy) would indicate that an expenditure could be of a substantial amount and still not be unreasonable.
Disqualifying Tests and the Qualifying Tests
Regardless of how successful the education is in meeting the qualifying" tests, it will, nevertheless, be nondeductible if it fails either of the "disqualifying" tests. For example, in the case of Burton, where the taxpayer attended law courses to assist in his decision-making activities, even if the employer had expressly required Burton to pursue a law degree, the term would, nevertheless, be disallowed because the education could result in the taxpayer's qualifying for a new trade or business. Similarly, in Davidson where the taxpayer attended accounting courses to meet the minimum educational requirements, even if an employer had expressly so required, the deduction would again be disallowed by the disqualifying tests.
Disqualifying Test and the Trade or Business Test
The reconciliation of these two tests is somewhat analogous to the previous discussion on the "disqualifying" and qualifying" tests. That is, regardless of how overwhelming the evidence is concerning the expenditure's fulfillment of the requirements of Sec. 162, the deduction will be disallowed if the education fails either of the disqualifying tests (minimum educational requirements or qualifying for a new trade or business). Each test is unique. That is, the education is tested against each criterion individually to arrive at the final determination as to deductibility.
TAMRA impacts Education
According to the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) proceeds received from Series EE bonds, including the interest thereon, may, in certain instances, be partially or totally excluded from income. Applicable to tax years beginning after 1989, the exclusion extends to bonds redeemed for purposes of financing qualified higher education.
To secure the exclusion, the proceeds must be used to finance the qualified higher education of the taxpayer, spouse, or dependents. interest accrued on the bonds may be excluded for extended periods, provided the proceeds are to eventually be used for qualifying higher education. Nonetheless, once the bonds are redeemed and proceeds received, excludable amounts are limited to the educational expenses actually incurred during the tax year.
TAMRA imposes a variety of restrictions on the exclusion provision, and should be referred to in determining whether the favorable treatment is, in fact, available. However, the provision will provide an opportunity, in many cases, for the taxpayer to obtain tax-subsidized education.
In addition TAMRA addressed the subject of employer-provided educational assistance programs. Although the exclusion for benefits derived from these programs under Sec. 127 lapsed at the end of 1987, TAMRA reinstated the exclusion to be applied retroactively for 1988. Consequently, individuals receiving benefits during 1988 under these programs are allowed to exclude from gross income up to $5,250 in benefits. The extension of the Sec. 127 employer-paid educational assistance exclusion does not apply for graduate level coursework. The restriction denying exclusion for graduate level courses leading to a business, law, medical or other advanced professional degree is applicable after 1987. However, the exclusion from income o tuition reduction benefits paid to graduate teaching or research assistants under Sec. 117 has been retained. Guidance concerning the taxpayer's treatment o employer-provided educational assistance can be found in IRS Notice 89-33.
Reporting the Deduction
Employees are allowed to deduct certain expenses in calculating adjusted gross income (AGI). These include reimbursed expenses for transportation, meals, lodging, and educational expenses, where the reimbursement is included in calculating the employee's gross income. These expenses should be reported on Form 2106. Deductible educational expenses which are not reimbursed are deductible from AGI as miscellaneous itemized deductions to be reported on Schedule A, if the taxpayer elects to itemize.
TAX PLANNING FACTOR 11. if the educational expense deduction win be greatly reduced by the 2% of AGI floor, it may be advantageous to have the employer reduce the taxpayer's salary and use the reduction to reimburse the educational expenses. (However, according to the Family Support Act of 1988, such an arrangement must be an "accountable" plan.)
If the employee is required to obtain education, reimbursed educational expenses need not be reported by the employee so long as the reimbursement does not exceed the related expenses and the reimbursement was not included in the employee's gross income. Expenses in excess of reimbursement are deductible as a miscellaneous itemized deduction on Schedule A. However, if the reimbursement exceeds the expenses, the excess is included in the employee's gross income. Self-employed taxpayers report the education deduction on Schedule C and, therefore, the educational expenses enter into the calculation of AGI.
A taxpayer pursuing an employment-enhancing educational program should plan to maximize the potential deduction. This includes choosing the source, type and extent of education which will survive the disqualifying tests and also meet one of the qualifying tests. The detailed process of evaluating, testing and reporting educational expenditures makes the deduction one which generates much controversy. A certain degree of scrutiny and forethought in planning may prove beneficial in reducing tax liability as well as increasing professional opportunities and income.
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