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.
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:
- The taxpayer must carry on a trade or business;
- The expense must be directly connected with the trade or business, and
- 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:
- The education is not required to meet the minimum education requirements for qualification in the taxpayer’s present trade or business;
- 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
- 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).
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.