Federal Income Tax Deductibility of Higher Education Expenses: The Good, the Bad, and the Ugly

• Author: James L. Musselman
• Position: Professor of Law at South Texas College of Law in Houston, Texas
• Pages: 923-981

Page 923

Introduction

Deductibility of educational expenses under the Internal Revenue Code (Code) has evolved into a fairly complex issue, much more so than necessary. The rules currently in effect for the deductibility of educational expenses were promulgated by the Internal Revenue Service (IRS) in 1967 and made a part of the Treasury Regulations (Regulations).¹ Much of the complexity of these rules relates to the deductibility of higher education expenses.

Higher education expenses are deductible, if at all (and with very limited exceptions), pursuant to section 162 of the Code, which provides a deduction for ordinary and necessary expenses paid or incurred in carrying on a trade or business.² The current rules for the deductibility ofPage 924 educational expenses are much more restrictive than for the deduction of business expenses generally, and they have been criticized accordingly.³

Courts have been wrestling with these rules since 1967 and have struggled to apply them in a consistent and meaningful way. For the most part, they have been successful. In recent years, however, the United States Tax Court has misapplied the tests set forth in the Regulations, resulting in an improper decision in at least one case.⁴

This Article will discuss briefly section 162 of the Code and its requirements for the deduction of business expenses generally; discuss briefly the history of the deduction of educational expenses under the Code (specifically, higher education expenses); explain in detail the Regulations adopted in 1967 that deal with the deductibility of educational expenses under section 162 of the Code; explain in detail each of the tests set forth in those Regulations and analyze cases that have been decided pursuant to those tests; and discuss the recent cases mentioned above in which the Regulations have been misapplied.

I General Discussion of Section 162

Even though a complete discussion of section 162 of the Code is outside the scope of this Article, a brief discussion is necessary to understand the intended purposes and application of the Regulations adopted in 1967 that deal with the deductibility of educational expenses under section 162. Section 162 generally provides a deduction for ordinary and necessary expenses paid or incurred in carrying on a trade or business.⁵

The United States Supreme Court discussed the meaning of "ordinary and necessary" in Welch v. Helvering.⁶ The Court assumed that the expenditures in question were "necessary for the development of the [taxpayer]'s business, at least in the sense that they were appropriate and helpful."⁷ Thus, the Court would apparently find expenditures necessary as long as they are sufficiently connected to a taxpayer's trade or business that they are appropriate and helpful to the conduct of that business, and asPage 925 long as they are not personal expenses.⁸ The Court was more obscure in its discussion of the meaning of "ordinary." The Court stated, "Ordinary in this context does not mean that the payments must be habitual or normal in the sense that the same taxpayer will have to make them often."⁹ Certain expenses "may happen once in a lifetime," but they are ordinary "because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means" of accomplishing a particular business purpose.¹⁰ The Court concluded its discussion of the meaning of "ordinary" by stating, "The standard set up by the statute is not a rule of law; it is rather a way of life. Life in all its fullness must supply the answer to the riddle."¹¹ Hence, the Court treated this issue as a question of fact.¹²

Section 162 allows a deduction only for "expenses," which means that they must not be "capital expenditures," which are specifically designated nondeductible under section 263 of the Code.¹³ INDOPCO, Inc. v. Commissioner¹⁴ is the United States Supreme Court decision establishing the current test to determine whether a particular expenditure is a nondeductible capital expenditure under section 263.¹⁵ In deciding that the expenditures incurred by the taxpayer in INDOPCO were nondeductible capital expenditures, the Court reviewed the long and often contradictory history of case law regarding capitalization of expenditures and adopted a test for capitalization that had been used by a number of Courts of Appeals.¹⁶ The Supreme Court stated, "Although the mere presence of an incidental future benefit . . . may not warrant capitalization, a taxpayer's realization of benefits beyond the year in which the expenditure is incurred is undeniably important in determining whether the appropriate tax treatment is immediate deduction or capitalization."¹⁷

In explaining its decision, the Court was careful not to represent this test as a bright-line rule or standard. In discussing immediate deductionPage 926 versus capitalization of expenditures generally, the Court enunciated a number of principles that it indicated must still be considered to resolve this question in specific cases.¹⁸ In that light, the test adopted by the Court is in reality only one factor, albeit an extremely important one, in determining whether expenditures should be capitalized or immediately deducted.

Section 162 requires that the expenses be paid or incurred in "carrying on" a trade or business.¹⁹ This generally means that the taxpayer must be presently engaged in an active trade or business to which the expenditures relate at the time they are incurred.²⁰ This requirement paved the way for the pre-opening expense doctrine.²¹ In Richmond Television Corp. v. United States,²² the taxpayer was attempting to deduct, under section 162 of the Code, expenditures incurred for the training of staff to operate a broadcasting business.²³ At the time such expenditures were incurred, the taxpayer had not yet acquired a license necessary to operate the business.²⁴The court held that the expenditures were pre-opening expenses incurred before the business was commenced, and were thus nondeductible under section 162.²⁵ In making its decision, the court focused in part on the requirement under section 162 that expenses be paid or incurred by a taxpayer in carrying on a trade or business.²⁶ The court determined that a taxpayer is "not 'engaged in carrying on any trade or business' within the intendment of section 162(a) until such time as the business has begun to function as a going concern and performed those activities for which it was organized."²⁷ The court held that the taxpayer was not carrying on any trade or business because the taxpayer had yet to acquire a license necessary to operate the business.²⁸

In some cases, a taxpayer has clearly been engaged in a trade or business for a period of time and has temporarily taken a leave from the business (in some cases to pursue education). In such cases, the issue isPage 927 whether the taxpayer continues to engage in the trade or business while on temporary leave so that expenses incurred in connection with the trade or business are deductible.²⁹ This issue will be discussed in detail later in this Article.³⁰

Finally, section 162 requires that the expenses be incurred while the taxpayer is carrying on a "trade or business."³¹ In Commissioner v. Groetzinger,³² the Supreme Court confirmed that, for purposes of section 162, whether a taxpayer is engaged in a trade or business depends upon an examination of the facts and circumstances of each case.³³ The Court stated, "[T]o be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and . . . the taxpayer's primary purpose for engaging in the activity must be for income or profit."³⁴ The activity of managing a taxpayer's investments in other entities (e.g., stocks and bonds) is not a trade or business, no matter how actively the taxpayer is involved in the activity.³⁵ Thus, an activity that would generate expenditures deductible only under section 212 of the Code does not constitute a trade or business under section 162 of the Code.³⁶

II Deductibility of Educational Expenses Under Section 162

A Pre-1967 Historical Discussion

As noted above, the thrust of this Article is to discuss the Regulations adopted in 1967 that deal with the deductibility of educational expenses under section 162 of the Code, to analyze cases that have been decided pursuant to those Regulations, and to explain two recent trends regarding the deductibility of educational expenses. A brief historical summary ofPage 928 the deductibility of higher educational expenses by courts and the IRS prior to 1967 will help one understand how the current rules apply to such expenses.

The deductibility of higher education expenses under the Code has gone through four phases.³⁷ Prior to 1950 (Phase I), virtually no higher education expenses were deductible.³⁸ Administrative pronouncements by the IRS and court decisions treated all such expenses as nondeductible personal expenditures.³⁹ In addition, it can be inferred from the United States Supreme Court's 1933 decision in Welch v. Helvering⁴⁰ that all educational expenses were nondeductible capital expenditures, no matter how related they were to the taxpayer's business.⁴¹ The Court stated that "[r]eputation and learning are akin to capital assets, like the good will of an old partnership,"⁴² and that "money spent in acquiring them . . . is not an ordinary expense of the operation...