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Copyright© 2006 Colin M. Cody, CPA and TraderStatus.com, LLC, All Rights Reserved. | |
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When reading this page, keep in mind that generally we are basically considering these overlapping areas of expense:
Tax Incentives for Education Costs Congress has given taxpayers several incentives that encourage higher education. The IRC contains various provisions for exclusions, deductions, or credits:
Unfortunately, most of these incentives have restrictions:
IRC Section 162 Provisions In the past, IRC section 162 has been a popular way for taxpayers to defray at least a portion of the costs of their graduate education. This provision permits employees to deduct expenses incurred for education as an ordinary and necessary business expense if the expenses are (1) incurred for either maintaining or improving existing skills in their present job, (2) meeting the express requirements of an employer or (3) meeting legal requirements necessary to retain their employment status. Many taxpayers who take a deduction for expenses incurred in the pursuit of an MBA degree do so with the intent of meeting the first criterion of improving existing skills in their present job. Treasury Regulations section 1.162-5 provides some clarification on the nondeductiblity of certain education costs. Although the education may maintain or improve skills required by an employer, education expenses under these two categories are specifically excluded as a deduction if:
The fact that a taxpayer is already performing service in an employment status does not establish that he has met the minimum educational requirement. A drawback of deducting education expenditures under IRC section 162 is that they are classified as miscellaneous itemized deductions, and as such are deductible only to the extent that they exceed 2% of adjusted gross income, and are subject to a phase-out for higher-income taxpayers. Given these limitations, section 162 has been a very popular method for taxpayers to write off their education expenditures for several reasons:
As stated, a taxpayer might rationalize the deductibility of the costs associated with pursuing either an MBA degree because it would presumably improve her skills. A taxpayer already in public practice or industry might argue that general classes are not a minimum educational standard for most jobs and many business-related jobs, and would probably not qualify the taxpayer for a new trade or business. A taxpayer could also argue that an MBA is not a minimum educational standard, because many older senior executives do not hold an MBA degree ("A Little Learning Is a Dangerous Thing to Deduct," by Albert B. Crenshaw, The Washington Post, July 22, 2004). Whether obtaining an MBA qualifies a taxpayer for a new profession is not so easily determined. As discussed below, the deductibility under IRC section 162 of the education costs of obtaining an MBA has been challenged by the IRS and upheld by the U.S. Tax Court on the basis that the MBA qualifies the taxpayer for a new trade or business. These decisions indicate that the IRS’s position is that taxpayers already working in a business field will no longer be able to deduct the cost of obtaining an MBA under IRC section 162. Robert Willens, a tax and accounting expert at Lehman Brothers Holdings, Inc., speculates that those claiming the MBA deduction may be more susceptible to IRS audits, and suggests that it is becoming virtually impossible to take a deduction for education expenses (Kim, August 17, 2004). Disadvantageous IRS Decisions and Court Rulings Several recent IRS letter rulings and Tax Court decisions give the impression that the education costs of obtaining an MBA will not qualify as an IRC section 162 deduction. The IRS has challenged the deduction and the Tax Court has affirmed the disallowance where employees worked in a business setting, maintained management positions, and sought to improve their existing skills. In a 1986 letter ruling (Letter Ruling 8714064) and again in a Tax Court summary decision (TC Summary Opinion 2002-49), taxpayers were denied a deduction under IRC section 162 for educational costs to obtain an MBA degree. In both situations, the taxpayers left their jobs in business to pursue the MBA. The IRS agreed in both cases that the taxpayers’ skills were maintained or improved by their course of study. However, the taxpayers were not required by their employers to obtain an MBA, and although the taxpayers did not intend to enter into a new career, the MBA qualified them to do so. Treasury Regulations section 1.162-5 specifically denies a deduction for educational costs that qualify the taxpayer for a new trade or business. Therefore the expenses were not "business expenses" as defined in section 162. In 2003, the Tax Court upheld the IRS’s decision to deny the deduction for an attorney’s education expenses in pursuit of an MBA degree (TC Memo 2003-68). The taxpayer, who held an LLM in corporate finance, was advised to obtain a JD degree to increase his marketability in a competitive environment. Subsequently, he chose to extend his studies by one year in order to obtain joint JD/MBA degrees. Although the attorney had worked as a summer associate for law firms while he was a member of the state bar, the IRS contended that his assignments and compensation were similar to other full-time non-attorney associates and thus he had not established himself in his trade or business as a practicing attorney. The court reasoned that it was necessary to break the education cycle and engage in a trade or business before deducting education expenses. In 2004, the IRS again denied a deduction for education expenses in the pursuit of an MBA degree by a financial analyst working in the investment banking industry (TC Summary Opinion 2004-107). In 1996, a financial analyst with a BA degree quit her job in the investment banking industry because of the long hours she had to work, and pursued an MBA full-time. To be promoted from “financial analyst” to “associate” in 1996, the investment banking industry required an MBA degree. Upon completion of her MBA the taxpayer took a position in the manufacturing industry in a “general management program” that required an MBA or equivalent. She argued that the expenditures were incurred to maintain and improve her skills and that the expenditures were required as a condition to the retention of an existing employment relationship. She focused on the similarities between her duties as a financial analyst and those of the associates at the investment banks firms where she had worked. As in the previous cases, the deduction was denied on the basis that the MBA qualified the taxpayer for a new trade or business. Although the duties of analyst and associate overlapped, the analyst position was a subordinate temporary position lasting for a maximum of three years. The IRS contended that the fact the taxpayer was already performing service in an employment status did not establish that she had met the minimum educational requirements for qualification in that employment. In its decision, the court agreed with the IRS and cited Treasury Regulations section 1.162-5(b)(3), stating that the expenses were not deductible even though the taxpayer did not intend to enter a new field of endeavor, and even though the taxpayer’s duties were not significantly different after the education from what they had been before the education. Issues to Consider A graduate degree can be an important asset to older taxpayers competing with the new generation of taxpayers who are entering the workforce holding MBAs. A taxpayer who wishes to deduct the cost of a graduate degree under IRC section 162 should consider several issues. The IRS may challenge a taxpayer on the cost of obtaining a MBA on the grounds that it prepares the taxpayer for a new trade or business. Whereas the MBA appears to be nondeductible, will the IRS and courts recognize general classes as simply an improvement of skills for the taxpayer? If a taxpayer quits a job and returns to school full-time, will the IRS and courts view this as a temporary suspension of employment, or as preparation for a new career? Acquiring a graduate degree is costly, and taxpayers should take advantage of any legal means to minimize that cost. Most taxpayers would agree with Judge Learned Hand’s observation in his 1947 court ruling (Comm’r v. Newman):
Based on recent IRS rulings and court decisions, however, taxpayers may have lost the power to obtain an IRC section 162 tax deduction for the cost of obtaining an MBA degree. It appears that it will be very difficult to get the deduction, and MBA students who claim the deduction should be prepared for an IRS audit. Will taxpayers see the MBA degree as a benefit to their professional career that surpasses the additional costs resulting from their inability to deduct their expenses? Or will they determine that general classes provide a comparable benefit, and one that satisfies the IRC section 162 regulations?
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November 14, 2008 TraderStatus™, TradersTaxPlan™, TradersAdvantage™, TraderStatus.com™, TradersTaxPlan.com™, TradersAdvantage.com™, DoYourOwnDaytraderTaxes™, DoYourOwnTaxes™, DoingYourOwnTaxes™, DoYourOwnDaytraderTaxes.com™, DoYourOwnTaxes.com™, DoingYourOwnTaxes.com™, DoYourTaxesOnline™, DoYourOwnTaxesOnline™, DoYourTaxesOnline.com™, and DoYourOwnTaxesOnline.com™ are trademarks and service marks of Colin M. Cody, CPA and TraderStatus.com, LLC, Trumbull Connecticut Copyright© 2006 Colin M. Cody, CPA and TraderStatus.com, LLC, All Rights Reserved |
