The deductibility of MBA degree expenses under Treasury Regulation 1.162-5: are you one of the lucky few who qualify?

• Author: Sanchez, Jill Kutzbach
• Position: Masters of Business Administration

1. INTRODUCTION II. BACKGROUND A. The Struggle with the Deductibility of Educational Expenses Prior to Regulation 1.162-5 1. A Change in History: The Hill Case in the Tax Court 2. A Change in History: The Hill Case on Appeal B. The IRS Releases Treasury Regulation 1.162-5 in 1958: The Subjective Standard C. The IRS Revamps Treasury Regulation 1.162-5 in 1967: The Current "Objective" Standard 1. The Objective Non-Deductibility of Educational Expenses in Fields of Study with Education and Examination Prerequisites 2. The "Objective" Approach to Educational Expense Deductibility in Fields of Study with No Formal Education or Examination Prerequisites III. ANALYSIS: THE SHORTCOMINGS OF THE "OBJECTIVE" STANDARD OF DEDUCTIBILITY UNDER REGULATION 1.162-5 WHEN APPLIED TO MBA DEGREE EXPENSES A. Losing Objectivity Through the Use of "Commonsense" B. Qualifying for a New Trade or Business with an MBA Degree 1. Comparing Education to Work Clothing 2. MBA Degree Expenses: Not What the Code or Regulations Contemplated C. "Commonsense" Produces Unfair Results D. "Commonsense" Leaves Room for Abuse IV. RECOMMENDATION: DENY EDUCATIONAL EXPENSE DEDUCTIONS FOR COSTS INCURRED TO OBTAIN AN MBA DEGREE IN ALL CIRCUMSTANCES A. Getting Back to an Objective Approach B. Promoting Equal Treatment Among Taxpayers C. Eliminating Opportunities for Abuse of Tax System D. Reduction of Administrative Costs E. Eliminating the Business Start-Up Expense Argument V. CONCLUSION I. INTRODUCTION

   Individual taxpayers incurring expenses for education face a significant challenge when determining whether those expenses are deductible as trade or business expenses for income tax purposes. The Internal Revenue Code ("Code") allows taxpayers to deduct "the cost of earning a living" by taxing their "net profits [from a trade or business] rather than ... gross receipts or gross income." (1) Therefore, employees can either deduct their employment expenses from gross income if the employer reimburses the taxpayer for those expenses or as a miscellaneous itemized deduction if the employer provides no reimbursement. (2) With respect to educational expenses, the threshold requirement for deductibility is that the expenses are incurred while "carrying on a[] trade or business." (3) After meeting this threshold requirement, Treasury Regulation 1.162-5 imposes four additional tests that the education must pass to qualify for deductibility. (4) Under these four tests, the education must not (1) be the "minimum educational requirements" for the taxpayer's position or (2) "qualify[] [the taxpayer] in a new trade or business," and the education must either (3) "maintain or improve [the taxpayer's] skills" or (4) be an "express requirement of the [taxpayer's] employer" for retention of the position. (5)

   The courts employ a number of different analyses and standards when determining whether educational expenses meet these four tests. (6) Thus, two different taxpayers incurring expenses for the exact same education could be subject to a different analysis and standard, depending on their unique circumstances, which could ultimately lead to contradictory outcomes. This inconsistency leaves a taxpayer hoping to get a deduction for educational expenses largely at the mercy of the judge.

   One specific type of education, the Masters of Business Administration ("MBA") degree, results in taxpayers falling victim to this disparity when determining the deductibility of expenses incurred to obtain the degree. In a recent case, the Tax Court allowed an employee of an orthodontic laboratory to deduct the expenses he incurred while pursuing an MBA degree. (7) The outcome of the case hinged on the "upward-bound" (8) disallowance test of the current regulation, which denies a deduction where the education "qualif[ies the taxpayer] in a new trade or business." (9) To determine the deductibility of the expenses, the court embarked on an in-depth analysis of the different tasks and duties the taxpayer performed at the orthodontic laboratory before and after obtaining his degree. (10) Ultimately, the court determined that the taxpayer did not qualify for a new trade or business with an MBA degree and thus, could deduct his educational expenses because the "courses provided him with a general background to perform tasks and activities that he had performed previously." (11)

   Conversely, in a 2002 case, the Tax Court deemed the expenses of obtaining an MBA degree non-deductible under the "upward-bound" (12) disallowance test. (13) The court found that the degree qualified the taxpayer in a new trade or business, regardless of his duties before and after obtaining the degree and regardless of whether he chose to enter those new trades or businesses. (14) Therefore, the outcome of an MBA educational expense case can turn entirely on the taxpayer's luck of the draw with respect to which of several standards of analysis the particular judge decides to apply.

   This Note analyzes the deductibility of expenses incurred to obtain an MBA degree by investigating the inconsistent outcomes, illustrated by the preceding cases, which result from the courts' varying applications of regulation 1.162-5. Part II of this Note examines the evolution of the educational expense deduction from the pre-regulation era to the current regulatory scheme. It also discusses the various approaches employed by the courts in applying the current regulation when they are considering expenses incurred for different types of education. Specifically, Part II.C.2 examines the cases involving the deductibility of MBA degree expenses and discusses the various analyses employed by the courts in those cases. Part III analyzes the effects of these various analyses and demonstrates the negative impact these approaches can have on taxpayers. Part IV suggests that the Internal Revenue Service ("IRS") and the courts should adopt a bright-line disallowance test for MBA educational expenses as an alternative to the multiple judicial approaches currently in use and outlines the suggested rule's likely effect on taxpayers and the tax administration system.

2. BACKGROUND

   Courts have struggled with the deductibility of work-related educational expenses for almost a century. To aid in determining which expenses should be deductible, the Treasury issued the original regulation 1.162-5 in 1958. (15) However, when that regulation proved unsuccessful at solving the problem, the Treasury issued an amended version in 1967, which is still in effect today. (16) While this new regulation provides clear guidance with respect to certain types of education, the deductibility of other classes of education remains unsettled. (17)

   1. The Struggle with the Deductibility of Educational Expenses Prior to Regulation 1.162-5

      The struggle surrounding the deductibility of educational expenses as business expenses originated in the 1920s. (18) In 1921, the IRS expressed its first position regarding the deductibility of educational expenses in two rulings. (19) The IRS ruled that "[t]he expenses incurred by school-teachers in attending summer school" (20) and the "[e]xpenses incurred by doctors in taking post-graduate courses" were personal expenses. (21) By deeming the expenses personal, the IRS automatically made educational expenditures non-deductible since the Code expressly prohibits the deduction of personal expenses. (22)

      The courts originally took a position similar to that of the IRS. In some of the earliest cases addressing this issue, the Board of Tax Appeals disallowed deductions for education expenses. (23) In Appeal of Driscoll, (24) the taxpayer had taken vocal lessons with the intent to begin a professional singing career. (25) The Board agreed with the reasoning of the Commissioner that "the expenditure ... was for educational purposes and of a personal character" and thus, the taxpayer could not take the deduction. (26)

      In contrast, the Board consistently allowed taxpayers to deduct the expenses incurred to attend conventions related to their field of work. (27) In Appeal of Shutter, (28) the Board ruled that a minister could deduct the expense of attending conventions, which were required for the maintenance of his status in the church. (29) Similarly, in Silverman v. Commissioner, (30) the Board allowed a professor to deduct the expenses he incurred to attend scientific conventions in an attempt to keep up with current issues in chemistry. (31) A possible explanation for the apparent disconnect in these early cases is that the Board did not consider expenses incurred to attend conventions to be "purely educational" (32) expenses; therefore, they were not personal, non-deductible expenses. (33) Instead, they qualified as business expenses for which the IRS allowed taxpayers a deduction. (34)

      1. A Change in History: The Hill Case in the Tax Court

         One of the most significant pre-regulation cases regarding the deductibility of educational expenses was Hill v. Commissioner, (35) which the Tax Court first decided in 1949. (36) Petitioner Nora Payne Hill taught high school in Virginia where teaching certificates expired every ten years. (37) The state required its teachers to pass examinations over five educational books or acquire three college credits to obtain a renewal of their certificates. (38) Ms. Hill chose to acquire three college credits to obtain her renewal, which she did by attending summer school at Columbia University. (39) The Tax Court found there was no evidence to prove that most teachers chose to attend summer school and, therefore, that option was not ordinary. (40) Furthermore, since Ms. Hill's future employment depended upon the renewal of her certificate, the court found that she incurred the expenses to qualify for the position and, as such, she was not carrying on a trade or business while in summer school. (41) Therefore, the expenses were personal and non-deductible. (42)

      2. A Change in History: The Hill Case on Appeal

         ...