Taxation of Employer Provided Education: A Look At Section 127 Plans

During a recent conversation that I had with another tax blogger, I commented about how many taxpayers fail to take advantage of Section 127 plans. This comment came up in a very brief mention of how Congress recently frustrated the tax plan of many parents who are saving for their children’s college education, by extending the kiddie tax – retroactively to begin in the 2006 tax year – from age 13 to 17. That got me thinking that perhaps I should write a short post about Section 127 Plans on this blog. Well, here is the result:

Basically Section 127 plans present employers with a streamlined means to deduct educational costs (up to $5,250 per year per employee) that might otherwise not be deductible to the employer and these plans allow the employee to exclude these amounts from their taxable income.

Absent a Section 127 plan, the education tax rules can be a bit, well, confusing. Absent a Section 127 Plan (and assuming that the Section 117 scholarship provisions are not applicable), the cost for education provided by employers to employees is (generally) deductible by the employer as an “ordinary and necessary” business expense and is excluded from the employee’s taxable income as a “working condition fringe” benefit, if the education is related to the employer’s business. If the education is not related to the employer’s business, then the employer is (generally) not entitled to deduct the costs and the employee is required to include these amounts in his or her taxable income.

A number of court cases have addressed what educational costs are related to the employer’s business pursuant to the applicable Treasury Regulations and, consequently, qualify as a “working condition fringe” benefit. The courts have essentially held that education expenses that allow the employee to meet the minimum educational requirements for qualification in their current job, qualify the employee for a promotion, salary increase, or a different position in a new trade or business do not qualify as a working condition fringe benefit. If the education expenses do not qualify as a working condition fringe benefit, then (generally) the expense is includable in the employees taxable income and not deductible by the employer.

I would hazard a guess that taxpayers have had great difficulty in applying these rules. Think back to your last employer-paid education. Can you determine whether your training is deductible as a working condition fringe benefit?

This is where Section 127 comes in. Assuming that the employer establishes a written Section 127 plan and complies with the applicable rules, the employer should be able to deduct expenses for up to the Section 127 limit even if the education does not qualify as a “working condition fringe benefit.” Taxpayers should note, that this also may help the employer from having to make arguments about how each education expense is an expense for education that is related to their business should the employer be audited by the IRS.

So what education expenses do Section 127 plans cover? These plans cover most costs for tuition, books, course supplies, and similar items for the employee (including undergraduate and graduate courses), but they do not include personal living expenses or any benefits for instruction involving recreational activities or for provision of tools or supplies which may be retained by the employee after completion of the course of instruction.

Do these plans bind employers to make continued cash outlays? No, employers can opt to fund or not fund Section 127 plans in any year, allowing employers to make contributions during good years and to forego contributions in leaner years.

Do these plans create administrative burdens for employers? Not really. Section 127 plans can be structured as educational reimbursement plans or they can provide education funds up front directly to the educational institution or to the student. Employers can specify what type or types of education that the plan will support; however, employers and their dependents cannot receive more than 5% of the benefits from these plans in any one year.

Given the increasing competition that Americans and the American economy are facing from foreign-educated workers, I think that Congress and the Treasury should strengthen and clarify provisions like Section 127 in an effort to encourage employers to provide educational assistance to employees (contrary to arguments that Congress should not use the tax code to impose social values on society, I do think that having an educated citizenry is one of the best investments and use of and for taxpayer dollars).

The Treasury could go a long way in this regard by publishing a sample or model Section 127 Plan, that, if employed, will meet the IRS requirements (much like the Service has provided model charitable trust documents). This would provide employers with a very simple and efficient means for implementing Section 127 plans. Congress could also increase the ante by upping the amount of education expenses that qualify for Section 127 treatment.