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How Not to Fund an Education

January 15th, 2012 No comments

Each year, millions of young individuals across the country face the question of whether or not to borrow funds to attend undergraduate or graduate institutions. Quite often, the question narrows: How much should one borrow?

There is no one size fits all answer to this question. As a result, one may seek advice regarding options. A competent adviser would be sure to tell a prospective student about, among other things, President Obama’s recent proposal to change some rules applicable to federal student loans. Then there’s incompetent and predatory advisers like Carla Ann Brennan.

The OC Weekly is reporting that Ms. Brennan was sentenced to seven years in prison last week.

Brennan was introduced to several students aged between 17 and 23 by her children. Brennan advised that she could assist these students with obtaining funding for their educations. She had them sign loan documents, and the lenders sent checks to the students for amounts ranging from $19,000 to $30,000. Brennan then met the students at a bank, where the students tendered the checks for cash. Brennan then told each student to keep $1,000 to $2,000, and she took the rest. The rest totaled $262,000.

Months later, the students received notices regarding repayment. Brennan said she was taking care of it. Instead, she was taking care of a tax liability she owed to the California Franchise Tax Board.

Eventually, the loans defaulted and a student contacted the the Orange County Sheriff’s Department. Of course, Ms. Brennan failed to demonstrate any legal justification for her actions.

She pleaded guilty to five felony counts of grand theft, five felony counts of money laundering, two felony counts of identity theft, one felony count of filing a false tax return, and sentencing enhancements and allegations for aggravated white collar crime over $100,000, loss over $100,000, and crime-bail-crime. She’ll have plenty of time to think about her actions while behind bars.

Categories: Education, Tax Fraud Tags:

All for the Wrong Reasons

November 12th, 2011 1 comment

On Wednesday night, I felt compelled to watch the press conference held by the Penn State board of trustees. “Joe Paterno is no longer the head football coach, effective immediately,” said John Surma, the vice chairman of the trustees and the CEO of Pittsburgh-based U.S. Steel.

The magnitude of the charges brought against former Penn State football defensive coordinator Jerry Sandusky didn’t begin to really hit me until I heard those words. Arguably college football’s most storied head coach and Sandusky’s immediate superior, Joe Paterno now leaves behind a legacy of gross negligence, incompetence, and utter disregard for the welfare of young and vunerable children, regardless of Jerry Sandusky’s criminal fate.

Unfortunately, it appears that the number of individuals known with involvement in the alleged cover-up will grow. Reported by Deadspin, the tax returns of Sandusky’s charity, The Second Mile, reveal that Sandusky received an annual consulting fee of $57,000 beginning in 2001. Sandusky stopped earning income from The Second Mile in 2009.

Although The Second Mile asserts on its web site that possible wrongdoing on Sandusky’s part was not brought to the charity’s attention prior to 2009, there are strong indications of otherwise. The Pittsburgh Post-Gazette reports that in 1998, attorney Wendell Courtney served as counsel for both Penn State and The Second Mile. At that time, Sandusky was under investigation for sexual misconduct with a minor male child taking place in a Penn State shower, according to the presentment by the investigating grand jury.

Jerry Sandusky founded the statewide non-profit organization The Second Mile in 1977 to provide support for at-risk children. This organization may have continued to pay—and hence support—Jerry Sandusky after it became aware of his possible sexual misconduct. It’s unfathomable enough to think that even one man is capable of the horrific acts alleged in the indictment. To think that the organization he founded facilitated the conduct makes you wonder how many people were aware this was going on.

At this point, all we can do is show our support for the victims and hope all those involved are brought to justice.

Help More Americans Manage Student Loan Debt

November 7th, 2011 2 comments

Educational debt has been and will continue to be a popular topic of discussion. Having borrowed to attend law school, I’m certainly paying attention. On October 25, President Obama made an announcement proposing some changes to federal student loans. The official White House press release is entitled “Help Americans Manage Student Loan Debt.” Although the proposed changes could affect several million borrowers, millions of financially distressed borrowers are not.

There are two components to the proposed changes: (1) a discount for loan consolidation and (2) accelerating changes to the income-based repayment (IBR) plan. Today I’m going to focus on (2).

The income-based repayment plan allows individuals with federal student loans to make monthly payments equaling 15% of the difference between the individual’s adjusted gross income and 150% of the poverty line for the taxpayer’s family size. If the individual makes timely payments for twenty-five years under IBR, then any outstanding balance remaining, including both principal and interest, is forgiven.

IBR is intended for individuals who don’t earn enough income to pay off their federal student debt under the traditional ten-year payment plan. I won’t highlight every detail about IBR here. For more information, be sure to check out IBRinfo.org.

Obama’s announcement addresses IBR terms. Prior to the announcement, in 2014 IBR payments will be capped at 10% instead of 15% and loans become eligible for cancellation after 20 years instead of 25 years. If Obama’s announcement becomes law, the changes to IBR will take place in 2012.

You would think that the changes impact anyone currently on IBR or who enrolls for IBR in the future. Not even close. In fact, anyone who graduated in 2011 or earlier and does not plan to take out any new federal loans won’t be able to benefit from the changes. To qualify, an individual must have at least one federal loan from no earlier than 2008 and also take out at least one more federal loan in 2012 or later.

Ultimately, the changes only impact some students attending school now or sometime in the future. Recent graduates from undergraduate and graduate programs struggling to make ends meet can’t take advantage.

As it stands, the IBR program does assist financially distressed students with avoiding default on their loans. There’s a tax angle here, however, that makes IBR quite a bit less appealing: Absent applicability of a narrow exception, the loan balance cancelled after twenty-five years is taxable income.

When a taxpayer incurs a debt, there is no taxable event because of the debtor’s promise to repay the principal. And when the debtor fulfills that promise, there is again no taxable event. If the cancellation of the promise to repay the principal does not create taxable income in the amount of the principal (and possibly interest), then taxpayers could avoid receipt of income by always structuring payments as loans followed by cancellation of the indebtedness.

That’s the general idea for having cancellation of indebedness income. One should look more closely at the economics of the transaction to evaluate whether one earned income—or put another way—whether one accumulated wealth as a result of the cancellation.

The U.S. Tax Court has made it clear that in general, cancellation of indebtedness from student loans is taxable income. For students seeking the benefits of IBR, a potentially big tax bill looms after twenty-five years of payments. There are efforts in place to change this result, but one cannot assume it will happen anytime soon.

Mailbag: Deducting MBA Tuition Expenses

July 6th, 2011 2 comments

Taxpayer asks: I left my consulting job to pursue an MBA degree. MBA tuition is expensive. Can I deduct the cost of tuition on my tax return?

Answer: Like to many seemingly straightforward tax questions, the answer is anything but: It depends. On a lot.

I’ll first mention that the Internal Revenue Code offers two types of credits for higher education expenses: (1) the American Opportunity and Hope Scholarship Credit; and (2) the Lifetime Learning Credit. These credits are very limited in amount and/or are subject to phaseout provisions.

With that said, let’s examine the circumstances a taxpayer may instead deduct expenses incurred for higher education. The basis for this possible deduction falls under section 162 of the Internal Revenue Code, which permits a deduction for ordinary and necessary business expenses paid or incurred during a taxable year in carrying on a trade or business. Section 162 does not explicitly grant a deduction for educational expenses, so we look to the regulations for it, and find two alternative tests for educational expenses as business expenses under Treas. Reg. § 1.162-5.

Section 162

Before proceeding to the regulation, I must note that the deduction for educational expenses as a business expense must meet the criteria of section 162 for business expenses in general as well as the requirements of Treas. Reg. § 1.162-5. The business expense deduction under section 162 has three elements:

  1. The taxpayer must carry on a trade or business;
  2. The expense must be directly connected with the trade or business, and
  3. The expense must be “ordinary and necessary.”

As applied to educational expenses, I’ll highlight a couple of noteworthy issues.

If the taxpayer is merely preparing to enter a new trade or business at the time the educational expense is paid or incurred, the expense does not qualify as a business expense. In various opinions, the U.S. Tax Court has expressly refused to set a certain length of time required to establish a trade or business in the context of deducting educational expenses. The outcome depends on the specific facts of that case.

Also, if a taxpayer ceased the former trade or business for a period of time prior to the commencement of education, then the educational expenses are almost always not deductible.

Treas. Reg. § 1.162-5

Under the regulation, an educational expense is deductible if the following criteria are satisfied:

  1. The education is not required to meet the minimum education requirements for qualification in the taxpayer’s present trade or business;
  2. The education is not part of a program of study pursued by the taxpayer that will lead to qualification in a new trade or business, AND
  3. The education either (a) maintains or improves skills required by the taxpayer in a trade or business, OR (b) meets express requirements of taxpayer’s employer or of applicable law or regulations, imposed as a condition to the retention a condition to the retention by the individual of an established employment relationship, status, or rate of compensation.

In short, a taxpayer must avoid disqualification under (1) and (2) and must satisfy either (a) or (b) under (3).

A few points about (1):

The minimum education requirements are determined by referencing the particular job, trade or business. They are determined on an objective, not subjective, basis.

In the context when an employed taxpayer seeks education to move to a better or different job, courts have taken two different approaches for ascertaining the relevant minimum educational requirements:

  • i) the minimum educational requirements of the position that the taxpayer holds while pursuing the education; and
  • ii) the minimum educational requirements of the employment to which the taxpayer aspires upon completion of the education.

For (2), the chief considerations at play:

  • (I) The Comparison Test: If the tasks and activities that the taxpayer was qualified to perform after the education are significantly different from before, the taxpayer is qualified for a new trade or business.
  • (II) The “Change of Duties” Rule: A mere change in duties that involve the same general type of work and qualification for a new trade or business does not disqualify the expenses as a deduction.  This applies in the context in which an employee seeks education leading to a change in duties.
  • (III) The Objective Standard: Like for (I), the focus is on whether the program or study actually qualifies the taxpayer for a new trade or business; the taxpayer’s intent is irrelevant.

Finally, some important points about (3). Remember, only either (a) or (b) under (3) need be satisfied.

For (a), which is satisfied if the education maintains or improves skills required by a taxpayer in a trade or business, here are the chief elements for consideration:

  • The skills required in the taxpayer’s trade or business;
  • The type of education the taxpayer seeks to deduct; and
  • The relationship between the education and the required skills.

To meet his/her burden of proof for (a), a taxpayer must be prepared to provide detailed documentation that demonstrates each of the chief elements for the particular facts and circumstances. Taxpayers have often attempted to demonstrate compliance with (a) by contending that the employer’s willingness to reimburse the taxpayer for the education is sufficient. Although such willingness may be relevant to the analysis, it is not necessarily sufficient alone.

For (b), remember it’s satisfied if the the education meets the express requirements for retention of an established employment relationship, status, or rate of compensation.

Courts have strictly construed the “retention” component. If the education meets requirements as a condition relating to anything other than other than an established employment relationship, status, or rate of compensation, the taxpayer won’t meet the requirements of (b). Indeed, education required to obtain a different position with the same employer, and not to retain the same position does not fall within the criteria of (b).

Concluding Remarks

A taxpayer who has educational expenses that seem to fall outside the ambit of Treas. Reg. § 1.162-5 will likely also fail in a challenge of the validity of the regulations, as many taxpayers have already tried unsuccessfully. Courts sustain the validity of a regulation unless inconsistent with a statute or unreasonable.

Ultimately, there is no straightforward answer to the question, because it depends on the particular facts and circumstances of the taxpayer. This discussion is merely an overview of the law, and should not be construed as tax advice particular to any taxpayer’s situation. A taxpayer who opines whether he/she meets the requirements for deductible educational expenses as a business expense should consult a tax professional to discuss all facts and circumstances.

Categories: Education Tags:
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