Tax Breaks for Employer-Paid Education Expenses

Is your business struggling with a shortage of skilled workers in today's tight labor market? One possible option is to invest in education programs to upskill your current employees. This strategy can help bridge the skills gap at your workplace and build loyalty among workers. Plus, the education may qualify for favorable treatment. Here are some possible options for employers and the related tax rules.

Reimbursements for Job-Related Qualified Education Expenses

An employer can give its employees unlimited tax-free reimbursements to cover qualified education expenses. In a nutshell, qualified education expenses are for education that:

• Is required by the employer or by law or regulation to retain an employee's current job, or
• Maintains or improves skills needed for an employee's current job.

The company can also directly pay qualified education expenses on an employee's behalf with the same favorable tax treatment. Such reimbursements or payments are tax-deductible and not subject to federal payroll taxes. 

Important: Qualified education expenses don't include costs for education that qualifies an employee for a new occupation or profession. If an employer pays for that kind of education, the payments count as additional taxable compensation for the employee, subject to income and payroll taxes—unless they're run through a Section 127 educational assistance plan.

Educational Assistance Plans

An employer can offer a Sec. 127 educational assistance program that gives each participating employee up to $5,250 in annual tax-free reimbursements. The employer can deduct the costs of operating a Sec. 127 plan as a business expense without owing any federal payroll taxes.

The tax rules permit these plans to cover just about anything that constitutes education, including graduate coursework, whether it's job-related or not. There are only two tax-law restrictions:

1. The education must be for the employee, rather than another member of the employee's family, and
2. The plan can't pay for courses involving sports, games or hobbies, unless they relate to company business.

Plans may reimburse employees only for education that's job-related. What's reimbursable is left to the employer's discretion when setting up the plan. Some companies don't do a good job of publicizing their Sec. 127 plans. So, if you do implement one, be sure to notify and remind employees about it, urging those interested to contact the HR department for more information.

As a bonus, Congress enacted legislation in 2020 that allows federal-income-tax-free treatment for payments made by employer-sponsored Sec. 127 educational assistance plans toward student loan debts of participating employees. This deal covers payments made under Sec. 127 plans through December 31, 2025. The annual limit is $5,250 for any combination of education expenses and student loan payments.

Eye on Advanced Degrees

In general, the cost of employer-provided education that qualifies an employee for new occupations or professions counts as taxable compensation subject to income and payroll taxes—unless the cost is run through a Section 127 educational assistance plan. However, you might have questions about the following types of higher education:

Master of Business Administration (MBA) degrees. If an employer pays for an employee's MBA, the IRS argues that it automatically trains the employee for a new profession. Thankfully, the U.S. Tax Court disagrees in certain instances. It says favorable qualified education expense treatment is allowed if the MBA program maintains or improves skills used in the employee's current job.

For example, a company can apparently cover the costs of its marketing director pursuing an MBA with tax-free reimbursements or payments because the education maintains or improves skills used in the worker's current job. The business can deduct the reimbursements or payments without owing any federal payroll taxes.

However, this taxpayer-friendly treatment isn't available if employees take MBA courses before or shortly after they're hired to meet pre-existing minimum educational requirements for their jobs.

Undergraduate degrees. The Tax Court agrees with the IRS position that an undergraduate college degree automatically prepares the graduate for a new occupation, profession or business. That means an employer can't make tax-free reimbursements or payments to cover the costs. Instead, employer-paid undergraduate degree costs will be treated as additional taxable compensation subject to income and payroll taxes. The employer can deduct the reimbursements or payments as compensation and deduct its share of the related payroll taxes.

Important: Some undergraduate courses may simply maintain or improve skills used in an employee's current job. In this case, the employer can treat the costs of those courses as qualified education expenses and cover them. Company reimbursements or payments for those courses will be tax-free to the employee and deductible by the employer without owing any federal payroll taxes.  

Juris Doctor (JD) degrees. The Tax Court says that a law degree automatically trains an employee for a new profession—even if the graduate has no intention of practicing law. So, an employer can't treat reimbursements or payments for law school as a tax-free benefit. The reimbursements or payments will be additional compensation subject to income and payroll taxes. The company can deduct the reimbursements or payments as compensation and deduct its share of the related payroll taxes.

Important: Costs to obtain a Master of Laws degree should fall under the same guidelines as MBA costs, because this degree doesn't allow a graduate to practice law. In addition, some courses in a JD program may simply maintain or improve skills used in an employee's current job. For instance, Mark is a controller. The cost of a law school course on basic business law would apparently pass the test to be treated as a qualified education expense. Company reimbursement or payment for that course will be tax-free to Mark and deductible by his employer without owing any federal payroll taxes.

For More Information

If your company has employees who want to take their skill sets to the next level, consider reimbursing education costs as a fringe benefit or setting up an educational assistance program. Doing so can keep your workers well trained and save taxes, too. Contact your SSB tax advisor to ensure you'll enjoy the tax advantages of employer-provided education benefits.

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