PORTFOLIO

Educational Expenses and Credits (Portfolio 517)

Tax Management Portfolio, Educational Expenses and Credits, No. 517-3rd, addresses the income tax treatment of expenses for postsecondary education. In general, the tax benefits discussed in this Portfolio apply when a taxpayer pays educational expenses for the taxpayer or the taxpayer's spouse or claimed dependents. Educational expenses may be deductible as business expenses or under a special deduction for tuition and fees. Alternatively, two education credits allow taxpayers to claim a credit for qualifying payments of tuition and related expenses. In addition to the deductions for payments of tuition and related expenses, another education-related deduction applies to interest on student loans. For each deduction and credit, there are numerous requirements for eligibility. Moreover, except for the business expense deduction, the deductions and credits for educational expenses are limited in amount and do not apply to taxpayers with higher adjusted gross incomes.

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DESCRIPTION

Tax Management Portfolio, Educational Expenses and Credits, No. 517-3rd, addresses the income tax treatment of expenses for postsecondary education. In general, the tax benefits discussed in this Portfolio apply when a taxpayer pays educational expenses for the taxpayer or the taxpayer's spouse or claimed dependents. Educational expenses may be deductible as business expenses or under a special deduction for tuition and fees. Alternatively, two education credits allow taxpayers to claim a credit for qualifying payments of tuition and related expenses. In addition to the deductions for payments of tuition and related expenses, another education-related deduction applies to interest on student loans. For each deduction and credit, there are numerous requirements for eligibility. Moreover, except for the business expense deduction, the deductions and credits for educational expenses are limited in amount and do not apply to taxpayers with higher adjusted gross incomes.

The first part of this Portfolio contains an introduction that shows how the deductions and credits discussed in this Portfolio relate to other education tax and non-tax benefits. In general, the education tax benefits are mutually exclusive. Thus, a taxpayer can use the deduction, credit, or exclusion that produces the maximum tax savings.
Educational expenses may be deductible as business expenses or qualified tuition and related expenses. To qualify for deduction as a business expense, an educational expense must be an ordinary and necessary expense paid or incurred in carrying on a trade or business. In addition, the education must either maintain or improve skills required in the taxpayer's employment or other business or meet the express requirements of the taxpayer's employer, or of applicable law or regulation, imposed as a condition to the retention of the taxpayer's established employment relationship, status, or rate of compensation. Even if the deduction requirements are satisfied, a business expense deduction is disallowed if the expenses are for education required to meet the minimum requirements of a taxpayer's trade or business or that is part of a program of study leading to the qualification of a taxpayer in a new trade or business. The deduction of travel expenses for education is prohibited or limited. The deduction of educational expenses as business expenses is discussed in Part II.

Educational expenses that do not meet the requirements for deduction as business expenses are considered nondeductible personal expenses, unless they qualify for a limited deduction for tuition and related expenses. Instead of deducting educational expenses, a taxpayer may claim one of two education credits: the American Opportunity Tax credit (or, for pre-2009 and post-2017, the Hope Scholarship Credit) or the Lifetime Learning Credit. The deduction for tuition and fees and the education credits generally apply to the same type of expenses: payment of tuition and fees incurred by an eligible student for higher education at an eligible educational institution. The requirements and limitations applicable to the deduction for tuition and related expenses and the education credits are discussed in Parts III and V, respectively. Those with student loans can derive a relatively small benefit from deducting interest paid on qualifying student loans obtained solely to pay qualified higher education expenses. The deduction for interest on student loans is discussed in Part IV.

Qualified scholarships and qualified tuition reductions, qualified tuition programs, Coverdell Education Savings Accounts, penalty-free withdrawals from IRAs for amounts used to pay qualified higher education expenses, forgiveness of student loans, and information reporting requirements related to higher education tuition and related expenses are discussed in 518 T.M., Exclusion of Scholarships and Other Receipts for Education.


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AUTHORS

CARLA NEELEY FREITAG
Carla Neeley Freitag, B.A., Duke University (magna cum laude, 1974); J.D., University of Florida College of Law (with high honors, 1976); LL.M. (in Taxation), University of Miami School of Law (1988); admitted to practice in Florida, Texas, and Georgia; member, American Bar Association; author, The Funding of Living Trusts (American Bar Association, 2004); contributor to Tax Practice Series; author of 462 T.M., Unrelated Business Income Tax — General Principles (§§511-513), 875 T.M., Unrelated Business Income Tax — Debt-Financed Income (§514), 539 T.M., Net Operating Losses — Concepts and Computations; 607 T.M., Farm and Ranch Expenses and Credits, and co-author of 863 and 521 T.M., Charitable Contributions: Income Tax Aspects; Tax Management Distinguished Author.

TABLE OF CONTENTS

Detailed Analysis

I. Introduction

II. Exclusion of Scholarships, Fellowships, and Other Receipts for Education

A. Introduction

B. Historical Perspective

1. Prior to 1954

2. 1954–1986

a. The 1954 Code

b. Amendment in 1980

c. The Deficit Reduction Act of 1984

3. The 1986 Code

C. Current Law

D. Section 117(a) Exclusion for Qualified Scholarships

1. Definition of “Qualified Scholarship”

a. In General

b. Definition of Scholarship or Fellowship Grant

(1) In General

(2) Bingler - The Quid Pro Quo Test

(a) In General

(b) Pre-1986 Case Law

(3) Employer-Employee Relationship

(a) In General

(b) Grants by Private Foundations

(4) Athletic Scholarships

(5) Payments of “Prizes” Denominated as Scholarships

(6) Self-Employment Taxes

c. Definition of Qualified Tuition and Related Expenses

2. Definition of Degree Candidate

3. Definition of Educational Organization

a. In General

b. Teaching Hospitals/“Apprentice” Work

4. Section 117(c) Exception from Exclusion for Payments for Services

a. In General

b. Health Professionals

c. Grants to Faculty Members/Students

d. Payments by or for the Benefit of Governmental Units

e. Employment Tax Issues

5. Recordkeeping Requirements

6. Requirements for Obtaining Private Rulings

E. Qualified Tuition Reduction Plans

1. Section 117(d)

2. Pre-1986 Case Law

F. Miscellaneous Exclusions Related to Education

1. Section 127

2. Section 132

3. Section 135

4. Christa McAuliffe Fellows

G. Interrelationship of 117 and 74 and 102

III. Deduction of Educational Expenses Under 162

A. Introduction

1. Summary of Requirements for Deduction

2. “Education” Defined

3. Items Eligible for Deduction

4. Important Considerations Concerning Case Law

B. Historical Perspective

1. Development of the Law

a. Before 1958

b. The 1958 Regulation

c. The 1967 Revision

2. Present Validity of Cases and Rulings Decided Under Prior Law

C. Criteria for Deduction

1. Introduction

2. Section 162

a. Trade or Business

(1) Established Trade or Business vs. Preparation to Enter New Trade or Business

(2) Temporary Cessation vs. Abandonment of Trade or Business

b. Required Relationship Between Trade or Business and Expense

c. “Ordinary” and “Necessary”

3. Regs. 1.162-5

a. Summary of Requirements

b. Nondeductible Educational Expenditures

(1) Nature of Disqualified Expenditures in General

(2) Minimum Educational Requirements for Qualification in Present Trade or Business

(a) In General

(b) Change in Minimum Educational Requirements After Employment

(c) Change in Employment

(d) Individual Employed Prior to Satisfying Minimum Educational Requirements

(i) Apprenticeships

(ii) Employment Subject to Condition

(e) Special Rules for Educational Institutions

(3) Qualification for New Trade or Business

(a) In General

(b) Comparison Test

(i) Comparison of Taxpayer's Qualifications Before and After Education

(A) Identification of Tasks and Activities

(B) Apprenticeships

(C) Overlapping Tasks and Duties

(D) Bachelor's Degree

(E) Guidance from State Law

(F) Actual Commencement of New Trade or Business

(G) Specific Trades or Businesses within General Field

(H) Generalist to Specialist within Same Trade or Business

(ii) Significance of Noneducational Requirements to Qualification for New Trade or Business

(iii) Significance of Taxable Year in Determining Effect of Program of Study

(iv) Deductibility of Particular Courses within Program of Study

(A) Degree Programs

(B) Other Programs of Study

(c) New Trade or Business vs. Change of Duties

(i) “Change of Duties” Rule

(ii) Teaching and Related Duties

(A) Special Rule

(B) Application of Special Rule

(C) Preferential Treatment under Special Rule

(iii) Application to Employees Other Than Teachers

(d) Objective Standard

(i) Taxpayer Does Not Intend to Engage in the New Trade or Business

(ii) Education Recommended, Encouraged, or Required by Employer

(iii) New Trade or Business Not Economically Feasible for Taxpayer to Pursue

c. The Qualifying Tests

(1) In General

(2) Maintaining or Improving Skills Required for Present Employment or Trade or Business

(a) General Considerations

(b) Trade or Business Skills

(c) Education

(d) Relationship Between Education and Skills

(3) Meeting Express Requirements for Retention of Established Employment Relationship, Status, or Compensation

(a) General Considerations

(b) Strict Construction of Terms

(c) Contexts for Determining Educational Requirements

d. Validity of Regs. 1.162-5

D. Limitations on Deduction of Educational Expenses

1. Limitations on Deduction of Travel Expenses Associated with Education

a. Travel as a Form of Education

(1) Deduction Disallowed for Taxable Years Beginning After 1986

(2) Prior Law: Taxable Years Beginning Before 1987

b. Travel Expenses Incident to Obtaining Education

(1) In General

(a) Primary Purpose Test

(b) Temporarily vs. Indefinitely Away from Home

(c) Travel Expenses of Spouses and Others

(2) Substantiation of Travel Expenses

(3) 50% Limitation on Deduction of Meals

(4) Foreign Travel Not Allocable to Trade or Business

c. Local Transportation Expenses Incident to Obtaining Education

2. Recipients of Tax-Exempt Educational Assistance from the Veterans’ Administration

3. Recipients of Scholarships and Other Excludible Educational Assistance

E. Tax Returns and Compliance

1. Form 1040

2. Substantiation

3. Penalties

IV. Qualified Tuition Programs

Introductory Material

A. In General

B. Definitions

C. Eligibility Requirements for Qualified Tuition Programs

D. Permissible Uses of Contributions

E. Former Penalties on Refunds

1. In General

2. Required Practices and Procedures for Identifying and Collecting Penalties

a. Distributions Must Be Treated as Payments of Qualified Higher Education Expenses

b. Penalty Collected on All Other Distributions

c. Refunds of Penalties

d. Documentation of Amounts Refunded and Not Used for Qualified Higher Education Expenses

e. Procedures for Collecting Penalties

F. Reporting Requirements

1. Return Filed with the IRS

2. Statement Furnished to the Distributee

3. Reports Between 529 Programs

G. Tax Treatment of Distributions

1. In General

2. Rollover Distributions

3. Additional Tax

4. Computing Earnings

a. Amount of Earnings in a Distribution

b. Adjustment for Certain Pre-1999 Distributions and Earnings

c. Examples

5. Change in Designated Beneficiaries

6. Aggregation of Accounts

H. Estate, Gift and Generation-Skipping Transfer Tax Rules

1. Contributions After August 20, 1996, and Before August 6, 1997

2. Contributions After August 5, 1997

a. Contributions That Exceed the Annual Exclusion Amount

b. Change of Designated Beneficiary or Rollover

3. Treatment of Estates of Decedents Dying After August 20, 1996, and Before June 9, 1997

4. Treatment of Estates of Decedents Dying After June 8, 1997

I. Advance Notice of Proposed Rulemaking

V. Coverdell Education Savings Accounts

A. In General

B. Qualified Education Expenses

1. Expenses for Higher Education

2. Expenses for Secondary Education

C. Eligible Education Institution

D. Contribution Limitations

E. Distributions

F. Transfers Upon Divorce or Death

G. Estate, Gift and Generation-Skipping Transfer Tax Rules

H. Other Rules

VI. Tax Credits for Higher Education

A. In General

B. The Hope Scholarship and American Opportunity Credits

C. The Lifetime Learning Credit

D. Definitions and Rules Applicable to Both Credits

1. Eligible Educational Institution

2. Qualified Tuition and Related Expenses

3. Academic Period

4. Phase-Out Rules

5. Timing Rules

6. Rules Applicable to Spouses and Dependents

7. Adjustments to Otherwise Qualifying Tuition and Related Expenses

a. In General

b. Relationship Between 117 and 25A Credit

8. Refunds of Expenses and Receipt of Educational Assistance in Later Tax Year

9. Recapture Provisions

10. Limitation Based on Tax Liability

VII. Interest on Educational Loans

A. In General

1. Treatment of Capitalized Interest and Certain Fees

2. Interest Payments Made During Periods When Not Required; Denial of Double Deduction

3. Third Party Payments; Legal Obligation.

B. Maximum Deductible Amount and Phase-Out Rules

C. Qualified Education Loan

1. In General

2. Qualified Higher Education Expenses

3. Eligible Education Institution

4. Eligible Student

D. Pre-2002 60-Month Limitation

1. Deferments and Forbearances

2. Late Payments

3. Refinancings, Consolidated Loans, and Collapsed Loans

VIII. Penalty-Free Withdrawal from IRA

IX. Forgiveness of Student Loans

X. Deduction for Qualified Higher Education Expenses

A. In General

B. Limitations

XI. Information Reporting Requirements

A. In General

B. Who Must File

C. Content of Information Returns

D. Payee Statements

E. Penalty for Noncompliance


WORKING PAPERS

Working Papers

Finding Aid

Other Sources

Worksheet 1 IRS Pub. 970, Tax Benefits for Education (Excerpt - Highlights of Tax Benefits for Education)

Worksheet 2 IRS Publication 17, Your Federal Income Tax (Excerpt - Employee's Educational Expenses)

Worksheet 3 Flow Chart - Taxation of Scholarships and Fellowship Grants

Worksheet 4 Flow Chart - Requirements for Deduction

Worksheet 5 Sample Form 8863

Worksheet 6 Digest of Cases by Type of Education

Bibliography

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Statutes:

Regulations:

Committee Reports:

Treasury Rulings:

Cases:

Tax Management Portfolios:

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