Ask not for whom the school bell tolls - tax treatment of employer-paid education expenses

Nation's Business, April, 1988 by Gerald W. Padwe

Ask Not For Whom The School Bell Tolls

Many employers adopted tuition-reimbursement programs in recent years, relying on a special tax rule that excluded employer-paid or reimbursed education expenses from an employee's taxable wages. This tax exclusion for tuition-reimbursement programs expired on Dec. 31, 1987.

This does not mean that all education reimbursements are now automatically taxable and subject to income-tax and FICA withholding. But if employers with these programs do not re-examine them immediately, both employers and employees could wind up paying unnecessary taxes.

Before education reimbursements were excluded from taxable wages in the late 1970s, such reimbursements were subject to oft-litigated tax regulations requiring a business purpose for deduction by the employee. Those rules are now back with us. An employee may deduct education or training expenses that help the employee maintain present skills. A deduction is not permitted, though, for the cost of courses that will qualify the employee for a new trade, business or profession.

Consider the irony: As long as you are satisfied to maintain the skills required for your present position, the Treasury will subsidize that lack of ambition with a tax deduction. Show some initiative, though, and take a course to qualify yourself for a better position, and the deduction disappears. Congress has made an interesting, if presumably unintended, endorsement of a questionable set of values.

Employer payments for nondeductible education expenses now must be treated just like any other compensation. The employer must withhold income and FICA taxes, and the employee must include the payments in taxable income.

Assume, however, that the employer's payments for employee education expenses:

* Meet the standard mentioned above-that is, the employer is paying to maintain the employee's existing skills; and

* Are treated by the employer as a reimbursement of an expense similar to any other reimbursement.

If those tests are met, the employer need not regard those expenses as wages subject to withholding. At the same time, the employee can avoid paying income tax on all or part of the reimbursements.

Since the exclusion rules expired Dec. 31, one presently unanswered question is the tax treatment of 1988 reimbursements for 1987 education expenses-reimbursement received in January, say, for tuition paid for a late 1987 term. There are preliminary indications that the IRS will look to the year expenses are paid, not to the year they were incurred. Thus, the payment described above may not be excludable.

Short Stops And High Hops From The World Of Taxes

Employee business expenses. Employer reimbursement of employee business expenses is more important now than ever, Starting in 1987, such expenses became so-called "miscellaneous itemized deductions," and they provide a tax benefit only to the extent they exceed 2 percent of adjusted gross income.

Take, for example, the employee-paid education expenses discussed above. To the extent they meet the standard for maintaining present skills, they result in a tax deduction to the employee-but only if they (in combination with other miscellaneous items) exceed the 2 percent threshold.

If, however, the employer reimburses the employee, the new rules provide that the 2 percent barrier does not apply to the deduction side. Thus, in effect, the employee has a "wash"equal amounts of income and expense-and the employer gets a full deduction for the reimbursement.

If the burden of the expense is left on the employee, but it is significant for a given employee, a solution may be salary renegotiation, reducing the employee's taxable wages and having the employer reimburse business expenses.

User fees. As part of its deficit-reduction efforts, Congress has imposed an unusual set of user fees on taxpayers seeking rulings from the Internal Revenue Service.

It is not uncommon, when a proposed tax transaction is somewhat complex or the tax dollars involved are substantial, to request a private ruling from the IRS as to how it will view the transaction. Such a ruling binds the IRS to its position-as long as you have disclosed all the material facts involved.

Now it costs money to submit a request for a ruling. You will have to pay a fee (generally ranging from $200 to $500, depending on the nature of your request) to get your request a place in line for consideration by the IRS.

If the IRS rules adversely to your position, it still keeps the user fee. If it declines to rule at all, though, it will refund your money.