Employee educational assistance: weighing the options. (Federal Taxation)by Segal, Mark A.
IRC Sec. 127 provides that an employee can exclude from gross income a maximum of $5,250 of employer provided educational assistance during a calendar year. To qualify for this exclusion, certain criteria must be met. These include--
* The employer must have a separate written plan;
* The plan must be for the exclusive benefit of employees;
* The plan must be for the purpose of providing employees with educational assistance;
* The plan must not discriminate in favor of highly compensated employees, or their dependents. (Excluded from this provision are a unit of employees covered by an agreement which the Secretary of Labor finds to be a collective bargaining agreement between employee representatives and one or more employers, if there is evidence that educational assistance benefits were the subject of good faith bargaining between employee representatives and such employer or employees.);
* No more than 5% of the amount paid or incurred by the employer for educational assistance during the year may be provided to a class of individuals who are shareholders or owners (or their spouses or dependents), each of whom (on any date of the year) owns more than 5% of the stock or of the capital or profit interest in the employer;
* There must be reasonable notification of the availability of the program provided eligible employees; and
* There must be satisfaction of certain reporting requirements; and
* Employees qualifying for exclusion of educational benefits under IRC Sec. 127 are prohibited from taking a deduction or credit for the amount of assistance received.
Understanding the Terms
The term employee includes--
* Retired, disabled, or laid off employees;
* Present employees on leave, e.g., those on active duty in the armed forces; and
* Self-employed individuals within the meaning of IRC Sec. 401(c).
Eligible costs include, but are not limited to tuition, fees, books, supplies, and equipment. These costs are eligible even if the courses taken lead to an advanced academic or professional degree. Ineligible costs include those for tools or supplies the employee may retain after completing the course of instruction and meals, lodging, or transportation. In addition, the cost of education relating to sports, games, or hobbies are ineligible, unless the education involves the employer's business, has a reasonable relationship to an activity maintained by the employer for profit, or is required as part of a degree program. The ineligibility of sports, games, or hobbies does not extend to education concerning how to maintain or improve health so long as the course does not involve the use of athletic facilities or equipment and is not recreational in nature.
The Working Condition Fringe Benefit Alternative
Although IRC Sec. 127 provides criteria that can assure exclusion from employee gross income, the potential benefit is limited to $5,250 per year. An alternative to IRC Sec. 127, expressly mentioned in the legislative history of RRA '93, is to have education benefits qualify as a working condition fringe benefit under IRC Sec. 132(d). IRC Sec. 132 does not prescribe dollar limitations, the requirement for a plan, or strict restrictions on what constitutes eligible expenses.
The IRC defines a working condition fringe benefit as "any property or service provided to an employee of the employer to the extent that if the employee paid for such property or service a deduction would be allowed under IRC Secs. 162 or 167." Reg 1.132-5(a) (1) (v) provides that an expense reimbursement will qualify for exclusion as a working condition fringe benefit should the employer require that--
* The payment be used in connection with a specific or prearranged activity or undertaking for which a deduction is allowed under IRC Sec. 162 or 167;
* Verification that the payment is actually so used; and
* Return to the employer of any part of the payment not so used.
Reg. 1.132-(5)(a)(1)(ii) indicates the two percent floor on miscellaneous itemized deductions is not considered in determining the amount of a working condition fringe benefit. The regulations go on to provide that no exclusion will be permitted absent satisfaction of the substantiation requirements of either IRC Sec. 162 or 274(d) and the regulations thereto. These requisites may be satisfied by substantiation through adequate records or sufficient evidence corroborating the employee's own statement. Thus, records provided by the employee and relied upon by the employer will generally be sufficient substantiation of a working condition fringe benefit.
From an employee perspective, where the exclusion of benefits from gross income under either IRC Sec. 127 or 132 is unavailable, other options must be considered to minimize the financial burden of re-education or retraining. Two such means are to qualify for deduction under IRC Sec. 162 or for exclusion as a qualified scholarship or fellowship under IRC Sec. 117. Understanding the requisites for deduction is also vital to qualifying as a working condition fringe benefit under IRC Sec. 132.
IRC Sec. 162. Deduction of employee education expenses requires satisfaction of IRC Sec. 162 and Reg. 1.162-5. To qualify for deduction, the expense must be paid or incurred during the taxable year in carrying on a trade or business. For this purpose Reg. 1.162-5(c) provides that educational expenses will be considered an ordinary and necessary business expense (even though leading to a degree) if the education is engaged in to either--
* Maintain or improve skills required by the individual's employment or other trade or business; or
* Meet the express requirement of the individual's employer, or of the law or regulation for retaining an established business relationship, status, or compensation rate.
Under Reg. 1.162-5(b), however, no deduction for education expenses will be permitted if the education either--
* Is necessary to meet the initial minimum education requirements of a job or trade or business; or
* Qualifies the taxpayer for a new trade or business.
Education required to meet a change in job requirements or duties is deductible. In addition, once a taxpayer has met the minimum education requirements for a job or a trade or business, the taxpayer is treated as continuing to meet those requirements even if they are subsequently changed.
An employee is generally deemed to be engaged in the employer's trade or business. The fact a person is already working as an employee, however, does not establish that the minimum education requirements for qualification in such employment have been met.
IRC Sec. 117. Another means of providing employees with educational assistance is through the establishment of a fellowship or scholarship program. Traditionally, employer-provided fellowships or scholarships have encountered stiff opposition from the IRS. The IRS has generally argued the amount received represents taxable compensation to the employee. As reflected in Bingler v. Johnson, where services must be provided for the grant, the grant will be treated as income. An exception to the inclusion of employer provided grants or fellowships in gross income is provided for benefits falling into the following two classes:
* Reductions of tuition for elementary, secondary, or undergraduate education where the worker is employed at the educational institution or another institution; and
* Exclusions or reductions of tuition provided by an educational institution to an employee for the education of the employee at the graduate level if the employee is a teaching or research assistant at the institution.
Although it is often difficult to attain exclusion for fellowships or scholarships provided by entities other than educational institutions, case law and IRS pronouncements indicate criteria that may enable such exclusion. These criteria include the establishment of a program by which fellowships or scholarships are made available based upon essentially (substantially) non-employment factors and are limited in relevance to academic qualifications. Factors deemed relevant include the establishment of an independent selection committee, the establishment of objective criteria regarding financial need and academic performance, and the absence of employee status or rank in determining scholarship or fellowship recipients.
The tax treatment of employee educational expense depends upon whether and to what extent the employee is reimbursed for such expense by the employer. If no reimbursement is forthcoming the allowable expense will be reported on Form 2106 and included in the group of miscellaneous itemized deductions subject to a two percent floor. Should a reimbursement be forthcoming the treatment of the reimbursement and expenses are dependent upon whether the reimbursement is received pursuant to an accountable plan. Typically if the expense is reimbursed in full under an accountable plan, the reimbursement will not be included in the employee's gross income, nor will the employee receive a deduction for the educational expense. Allowable expenses incurred in excess of the reimbursement will be reflected on Form 2106, and included in miscellaneous itemized deductions subject to the two percent floor. Where reimbursement is not made under an accountable plan, the reimbursement is included in the employee's gross income (reflected on the employee's W-2). The allowable educational expense is then reflected on Form 2106, and included in miscellaneous itemized deductions subject to the two percent floor.
Coping with Retroactive Effect
The retroactive extension of the IRC Sec. 127 exclusion raises questions and administrative concerns. Particularly significant is the fact the extension is made retroactive to June 30, 1992. Thus, it affects returns already filed.
On September 16, 1993, the IRS issued guidelines concerning how the retroactive extension of the IRC Sec. 127 exclusion should be handled. According to the guidelines, employers are encouraged to refund Social Security and Medicare over withholdings to employees. These refunds would be affected by adjusting their tax liability deposit to the IRS on Form 941. These adjustments can be explained on Form 941C.
Employees eligible for a refund of income tax will have to obtain a revised W-2 (Form W-2c) from their employer and file an amended tax return (1040X). A special procedure has been developed to enable taxpayers pursuing refunds to have their refund requests processed more quickly. This entails employees filing a signed Form 1040X that includes their name, social security number, and "1992 tax year" and writing "IRC 127" on the top margin.
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