Tax Ramifications of Educational Benefits
Q: As a way to give back to my employees, I'd like to send some key employees to training and education courses. I've been told that these expenses may not be deductible to my business and that I have to establish a written employee benefit plan for this purpose. How do I tell whether these expenses are deductible and whether I have to set up a plan?
A: The deductibility of educational expenses depends on timing and whether they're ordinary and necessary to your business. An ordinary expense is common and accepted in your particular business activity. An expense is necessary if it's appropriate and helpful in your business.
As far as timing goes, cash-basis taxpayers, which many sole proprietors are, deduct expenses when paid. Accrual-basis taxpayers deduct expenses in the year the expenses were incurred.
With that said, the rules relative to deductibility of educational expenses can be confusing at best. Our starting point is whether an expense is a qualified or nonqualified educational expense. Qualified educational expenses meet the following criteria:
- They're required by the employer or the law to maintain the employee's present salary, status or job. The required education must serve a bona fide business purpose for the employer; or
- The education maintains or improves skills needed in the employee's present job.
A nonqualifying educational expense is defined as follows:
- It's needed to meet the minimum educational requirements of the employee's present trade or business; or
- It's part of a program of study that can qualify an employee for a new trade or business.
Generally, an expense that's ordinary and necessary will be considered to serve a bona fide business purpose. Therefore, if your business pays qualified educational expenses for your employees, the expenses will qualify for deduction to your business.
If employees are reimbursed for qualified educational expenses under an accountable plan, the expenses are also deductible to your business and excludible from the employee's wages. A plan qualifies as an accountable plan if it meets the following requirements:
- The expenses have a business connection; in other words, the expenses must be deductible as qualifying education as discussed above.
- The employee must account for expenses to the employer in a reasonable amount of time.
- Employees must return any reimbursement in excess of the expenses accounted for to the employer in a reasonable amount of time.
Tuition, books, supplies, lab fees, similar costs and certain transportation costs are generally deductible. For more information on which expenses are deductible, take a look at IRS Publication 508: Tax Benefits for Work-Related Education.
In situations where an employee incurs out-of-pocket qualified educational expenses that aren't reimbursed by the employer, the employee may qualify for a deduction on their Form 1040. When aggregated with other miscellaneous itemized deductions, the amount must exceed the 2 percent of adjusted gross income miscellaneous itemized deduction floor to obtain a deduction. In contrast, self-employed individuals may take their qualified educational expenses as a deduction on Schedule C of the Form 1040.
Employers are typically inclined to pay for educational expenses that closely relate to their businesses. However, some employers have established written employer-provided educational assistance plans under Internal Revenue Code section 127.
If an employer establishes a written section 127 plan, the employer can exclude up to $5,250 of employer-provided education assistance from an employee's wages. The section 127 plan rules have been expanded to include undergraduate-level courses when the employee begins coursework before January 1, 2002. Expenses for education relating to sports, games or hobbies aren't eligible for this exclusion, except in the case where the education has a reasonable relationship to the business of the employer.
In the case of graduate level education, a section 127 plan generally only covers job-related education that meets the qualifying educational expense requirements discussed above. Graduate courses in law, business, medicine or other advanced academic or professional degrees won't qualify for exclusion under a section 127 plan since they're deemed to qualify the employee for a new trade or business.
My suggestion to you is to first consider creating qualifying educational expenses since they'll benefit both your employee and business. If you want to expand employee benefits, then consider establishing a section 127 employer-provided educational assistance plan.
Education is definitely a hot topic these days, especially considering how difficult it is to find and retain good employees. If you have employees worthy of the investment, education-related incentives are a great way to build loyalty and human resources for your business.
Laura A. Collins is a CPA and freelance writer with more than 18 years' experience in finance and taxation. She writes from her home in Greensboro, North Carolina.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.