The deductibility of graduate education expenses: without specific legislative or regulatory guidance it's up to the courts.

AuthorPope, Thomas R.

Without Specific Legislative or Regulatory Guidance It's Up to the Courts

The deductibility of education expenses continues to be an area in the income tax law that results in a great deal of confusion and uncertainty. The principal reason for this tumultuous state of affairs is the lack of specific legislative or regulatory guidance for taxpayers. The regulations that serve as the authority for deducting educational expenditures are extremely general and nonspecific in nature and have led to the courts having to interpret the tax consequences of specific circumstances. As a result, there are literally hundreds of cases, spread across a broad range of factual situations, that taxpayers must traverse to determine whether or not their education expenses are deductible.

This article will examine the key factors that taxpayers must consider in deducting graduate education expenses. The focus is on graduate education expenses because the majority of problems are encountered there, and the law is surprisingly clear in undergraduate education and continuing professional education. Undergraduate education expenses are generally nondeductible unless the college course is an isolated course that is not part of a program of study leading to a degree. Continuing professional education, on the other hand, is deductible, assuming it is sufficiently related to the taxpayer's current job.

While there are a number of factors that must be considered in determining the deductibility of graduate education expenses, two factors stand out: First, the taxpayer must actually be in a trade or business at the time the education is incurred. A taxpayer who is either a full-time student or not actively engaged in a trade or business at the time the education is undertaken may have a difficult time supporting the deduction. Second, if the education qualifies the taxpayer for a new trade or business, the expenses connected with such education are not deductible.

Basic Rules

The deductibility of education expenses is not specifically provided for in the Code. The regulations under Sec. 162 provide the authoritative rules. The placement of the rules under Sec. 162 clearly establishes that the deductibility of education expenses rests on the association of such expenses with the taxpayer's trade or business. While many expenses for education are considered personal in nature and, therefore, nondeductible, Regs. Sec. 1.162-5 provides that education expenses must be connected with a trade or business and then tested against four criteria to determine whether they can be deducted. The expenditures must first be tested against two negative criteria and, assuming that neither disallows the expenditures, they must then meet one of the two positive criteria.

* Negative criteria: The regulations provide that if either of the two negative criteria is present, such expenses will not be allowable. 1. Education expenses that are required of the taxpayer in order to meet the minimum educational requirements for qualification in his employment or other trade or business,(1) or 2. Education expenses that are part of a program of study which will qualify the taxpayer for a new trade or business.(2)

The terms "qualification" or "qualify" are of critical importance. A common thread of many cases decided for the IRS is that the education obtained qualified the taxpayer for a new trade or business even though the taxpayer had no intention of actually entering the hypothetical trade or business. Qualification alone was sufficient. * Positive criteria: The regulations provide that if either of the two positive criteria is present and neither of the two negative criteria applies, an education expenditure is deductible. 1. Education expenses maintain or improve skills required by the individual in his employment or other trade or business,(3) or 2. Education expenses meet the express requirements of the individual's employer, or the requirements of applicable law or regulations, imposed as a condition to the retention by the individual of an established employment relationship, status or rate of compensation.(4)

Under both criteria, the expenses must be in connection with the taxpayer's employment or trade or business. Thus, a taxpayer must demonstrate that the education has a proximate relationship to skills required in his current job or trade or business. Second, the taxpayer must be in a trade or business at the time the courses are taken. Many taxpayers have had education expenses disallowed because they were not considered to be in a trade or business at the time the expenses were incurred.

Clearly, all of these factors have resulted in controversies between taxpayers and the IRS. However, the two factors causing the preponderance of litigation are (1) the presence of a trade or business at the time the expense is incurred and (2) whether the education qualifies the taxpayer for a new trade or business.

Engaged in a Trade or Business

In order to deduct education expenses, a taxpayer must be engaged in the "carrying on" of a trade or business. This "carrying on" can be in connection with either his capacity as an employee or as a self-employed individual in a trade or business. A parttime student who is employed on a full-time basis or has his own trade or business would certainly meet this test. Full-time students, however, face more difficulties, especially those who are not currently employed. The IRS stated its original position in Rev. Rul. 60-97.(5)

A taxpayer who is not currently employed or is not otherwise actively engaged in a trade or business is not entitled to a deduction for the expenses of any education undertaken during such period of unemployment or inactivity .... A taxpayer will not be considered to have ceased to engage in his employment or other business during an off-duty season, when he is on vacation, or when he is on temporary leave of absence.

Thus, in essence, a full-time student was virtually prohibited from deducting education expenses unless he was on a temporary leave of absence. This position was softened somewhat in Rev. Rul. 68-591,(6) which provided that education expenses will be deductible if the taxpayer only "temporarily ceases to engage actively in employment or other trade or business." (Emphasis added.) The ruling defined temporary as a suspension period of one year or less. This change of position allowed a taxpayer who resigned permanently from his present job, rather than merely taking a leave of absence, to deduct his education expenses. Rev. Rul. 68-591 was prompted by the Seventh Circuit's decision in Furner,(7) which involved a teacher who resigned her teaching position to pursue graduate education for one academic year and, on graduation, accepted a teaching position at a different school. The original school's policy was not to grant leaves of absence. The Tax Court agreed with the IRS that Furner was not engaged in "carrying on" a trade or business at the time the education was being undertaken, and disallowed the...

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