Deductibility of Advanced Business Degrees

By Cynthia Bolt-Lee

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The costs and benefits of the degree and its affect on lifetime earnings are obvious. Another substantial factor to consider is that the costs of acquiring the degree are often tax-deductible. For qualifying individuals, the tax savings are substantial, as the individual’s AGI often lowers during graduate school attendance, resulting in a more beneficial deduction. For self-employed individuals, the deduction lowers AGI and income subject to self-employment, resulting in even greater tax benefits.

The allowance of the deduction for education expenses is included in IRC section 162 under the wide-ranging concept of “a deduction of all the ordinary and necessary expenses … in carrying on any trade or business.” Further analysis of this deduction reveals certain complexities in determining qualified education expenses.

Treasury Regulations section 1.162-5 (last revised in 1967) expands, explains, and provides examples related to the specifics of the deduction of education expenses. In general, the following must be met for the expense to be deductible:

• It is not required in order to meet the minimum educational requirements for qualification in employment, or other trade or business;
• It is not part of a program of study which will lead to qualification for a new trade or business; and
• It will maintain or improve skills required by the individual in employment or other trade or business, or
• It meets the express requirements of the individual’s employer, or meets the legal requirements to maintain the individual’s employment, status, or rate of compensation.

The U.S. Tax Court has recently taken issue with the construed standard of maintaining and improving skills required for employment, as opposed to improving competence necessary for a new position. More specifically, the general nature of a business program, with the variety of courses ranging from accounting to electronic commerce, combined with the sizable tuition charged by top-ranked graduate schools, has broadened the nature of the deduction and caused the IRS and courts to examine the issue more closely as it relates to the MBA or other postgraduate business management degrees.

Inconsistencies exist with the various court and IRS rulings on this topic. An analysis of the more prominent issues contained in the IRC and Treasury Regulations provides a useful gauge to assess the possibility of sustaining a deduction.

Ordinary and Necessary Expenses of a Trade or Business

The broad requirements contained in IRC section 162 provide the foundation for the education deduction. The trade or business determination includes continuous and regular activity for income or profit at the time the expenses are incurred. Without this minimum level of compliance with section 162, the education deduction will be disallowed. The courts have generally considered employees to be engaged in a trade or business.

The definition of education expenses reaches beyond the standard tuition, fees, and books. Costs associated with a management consultant hired for private tutoring have been allowed. For those individuals incurring expenses “away from their tax home,” travel, transportation, meals, rent, utilities, and lodging qualify. A 1982 case reiterated that if the taxpayer’s costs were primarily educational versus personal, the business aspect of the deduction is the primary motivation, and as such they are deductible. Commuting expenses are nondeductible, however, unless incurred from work to the class where qualifying education expenses occur.

The Supreme Court addressed these requirements by stating that, under IRC section 162, “to qualify for the business deduction the expense must relate to the existing, as opposed to the future, occupation of the taxpayer.” Relying on this decision, Revenue Ruling 77-32, which was foundational in its definition of “existing” trade or business, disallowed an anesthesiologist’s deduction of expenses related to maintaining his skills during a time when he was not practicing medicine.

Courts have allowed a leave of absence from work to pursue an MBA degree as long as the taxpayer assumes a similar job upon return. A 1977 case concluded that the IRS would accept periods of less than a year’s absence from employment. Longer periods have been accepted if the taxpayer actively sought a position upon graduation. A 1970 tax court case allowed a taxpayer a two-year absence from work because he returned to a comparable position as manager at another business.

Individuals with an undergraduate degree that work for a short period of time (such as a summer position) and return to an MBA program generally are disallowed a deduction. The taxpayer must be in the workplace long enough to be engaged in an active trade or business.

Recent cases have involved variations of the trade or business requirement. In Weyts (TC Memo 2003-68), a non–U.S. citizen taxpayer held a law degree from Belgium, and received a Master of Laws (LLM) in corporate finance in the United States. He passed the New York State bar exam before obtaining work as a summer associate, and was advised to return to school to obtain his JD degree. The courts determined that admission to the bar was not necessarily considered “engaged in a trade or business of practicing law” and the costs in question were related to obtaining the minimum education (JD) necessary for a position after graduation; therefore, the deduction was disallowed.

Maintain or Improve Skills Required by an Employment

The regulations provide the detailed language regarding the allowance of the deduction. First and foremost, the taxpayer must be involved in a trade or business or employment situation where the education expense is required due to the necessary maintenance or enhancement of the individual’s skills.

The Tax Court has said that the education need only “enhance the taxpayer’s existing skills” and that the education obtained should have a “direct and proximate relationship” to the business purpose of the individual’s employer. Only the minimum education necessary for retention qualifies. Nonetheless, a change in responsibility does not constitute a new trade or business if the new duties involve the same general type of work.

The fact that an individual is already performing service in an employment status does not establish that he has met the minimum educational requirements for qualification in that employment. Yet once met (when effectively entering employment, or the trade or business), the employee shall be treated as continuing to meet those requirements even though they are changed.

The courts delineate between the improvement of skills and the improvement of oneself. For the MBA degree, this generally requires the taxpayer to have some type of administrative or management position involving interpersonal and communication skills prior to receiving the education. Courts and the IRS disallow a deduction where the skills acquired through the educational expense appear to be only remotely related to the profession (lack of proximate and direct relationship). Representative cases included the disallowance of an MBA for an army attorney, an airline pilot, and a quality-control foreman.

Education Expenses Required by Employer or Law

The regulations, which are very specific in this area, indicate that the education must meet the express requirements of the individual’s employer, the law, or applicable regulations for retaining an established business relationship, status, or compensation rate. This includes education customary for others in the profession to obtain similar education for the retention or enhancement of competencies. Taken literally, the education expenses must be specifically required, either in writing or by other explicit communication. Does an employer “require” an MBA from an employee? Does the employee assume that, in order to maintain competence, further education is necessary?

A 1978 case involved an engineer who was reimbursed by his employer for costs associated with his MBA. The courts disallowed the deduction by the business, indicating that the business reimbursement policy was more relaxed than the law, and thus the reimbursed costs should be considered income to the recipient.

A 1969 Revenue Ruling allowed a navy captain to deduct his Master of Arts in Personnel Administration. This ruling acknowledged that although the degree was not required by the employer for retention, promotion, or salary enhancement, and the taxpayer chose to take the courses of his own accord, the courses were nonetheless “so closely related to his employment duties that they served to maintain or improve the skills required of him in his employment … and the courses taken by the taxpayer were not part of a program of study that would qualify him for a new trade or business.”

The decision in McEuen (TC Summary Opinion 2004-107) made the popular press after the taxpayer was denied the deduction of the cost to obtain an MBA at Northwestern. After an undergraduate degree, McEuen worked for two financial analyst firms where it was known that an MBA was a prerequisite for promotion. She resigned her position to obtain the degree, but after graduation worked in industry in general management, where an MBA was required. The court stated that McEuen performed significantly different tasks and activities after receiving her MBA.

Qualifying for a New Trade or Meeting Minimum Educational Standards

Courts examine the taxpayer’s ability to perform significantly different tasks and activities after obtaining additional education, thus providing support for new competencies versus the enhancement of existing skills. Specialties obtained must be in the same general type of work. The degree-seeking individual must return to the same general type of work. Consequently, education expenses that appear to provide opportunity for position advancement are examined carefully.

Specific disciplines appear to be scrutinized differently. Teachers receive some leniency when required to obtain additional competencies in order to teach in a new school district. Attorneys, however, have been disallowed a deduction related to costs incurred to practice law in a new state. Revenue Ruling 74-78 allowed a dentist practicing general dentistry to deduct the costs of postgraduate studies in orthodontics even though, following the completion of his degree, he limited his practice to orthodontic patients. Costs for law school, however, regardless of whether required by the employer or used in the professional’s job, are specifically considered nondeductible by the regulations.

These conservative interpretations have been affirmed more recently in Galligan (TC Memo 2002-150). The taxpayer, a law-library manager, obtained a law degree to enhance skills used daily in her position. She did not practice law, and her employer did not require the degree. Galligan argued that the $18,000 spent on the cost of her education maintained and enhanced her skills, but the court disallowed the deduction.

Examining IRS- or court-approved deductions in the legal, education, and dentistry professions provides a basis for evaluating whether an advanced business degree will qualify as a legitimate deduction. In Lewis (TC Summary 2002-49), the taxpayer attended UCLA’s MBA program to obtain additional business skills. Lewis stated that he needed to enhance his accounting, financial, and general business skills to help with contract negotiations in his current position. He agreed that the MBA would also qualify him for a “wider variety of positions.” The courts disallowed the deduction.

Zhang (TC Summary Opinion 2003-58) addressed an individual receiving an MBA from the Massachusetts Institute of Technology. A large brokerage firm assured the taxpayer that he would have a job upon completion of his education. The court considered this to be a new trade or business, and the deduction was disallowed.

Analysis

IRC section 162 permits ordinary and necessary expenses required to carry on a trade or business, including costs associated with qualifying education. The regulations give extensive details on what kinds of education qualify (maintaining or improving skills, meeting requirements for employment retention) and what kinds do not (qualifying one for a new trade or business). These generalized requirements can be a challenge for taxpayers to interpret, but the courts have maintained a strict analysis and generally support the IRS interpretations.

Examining court and IRS rulings provides critical information for taxpayers considering the deduction. The courts and the IRS have shown more leniency in certain disciplines, such as education and dentistry, than in others, such as business and law. Education expenses that either potentially or directly allow position advancement are generally disallowed.

For advanced business degrees, these issues are seldom black and white. Court rulings differ widely from case to case. Generally speaking, the courts and the IRS appear to be continuing their conservative approach when interpreting the requirements of qualifying deductible education expenses. Taxpayers will be more likely to secure the education expense deduction if they have fully researched all the related issues and rulings.