Deductibility of MBA Educational Expenses Under the Allemeier Opinion

By Homer L. Bates and Bobby E. Waldrup

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IRC section 162 allows for the deduction of ordinary and necessary expenses incurred in carrying on a trade or business. Treasury Regulations section 1.162-5 details the guidelines for determining which educational expenses incident to a taxpayer’s trade or business are deductible. The IRS’s guidelines for determining the deductibility of work-related education, from Publication 970, are illustrated in Exhibit 1.

In 2002, the Tax Court ruled in Galligan (TC Memo 2002-150) that a law librarian could not deduct her law school expenses because the expenses qualified her for a new trade or business. She argued that attending law school improved and maintained her skills as a law librarian. The court argued that even though this argument was valid, the program of study also qualified her for a new trade or business. Because of the law degree, she became eligible for admission to the state bar and to enter the general practice of law. It was not relevant that it also helped her in the performance of her duties in her present position. In McEuen (TC Memo 2004-107), the taxpayer was denied the costs of obtaining an MBA from Northwestern University. She was employed by two financial analyst firms after receiving her baccalaureate degree. It was known at these firms that an MBA was required for promotion. She resigned her position and entered and completed the MBA program at Northwestern University. After graduation, she took a position that required the MBA. The court denied the deduction, ruling that the tasks and activities at her new position were different than those at her previous position and, therefore, the MBA qualified her for a new trade or business.

In Sherman (TC Memo 1977-301), the Tax Court sided with the taxpayer and allowed the deduction of his expenses incurred in receiving his MBA from Harvard University. Sherman was employed by the Army and Air Force Exchange Service as a manager. Upon being accepted into the Harvard MBA program, he requested a leave of absence, which was denied. He resigned and completed his MBA program two years later. He reapplied to the Exchange Service, but a position was not available. He then accepted a corporate managerial position. The IRS argued that Sherman was not in a trade or business at the time he incurred the educational expenses. The Tax Court disagreed with the IRS and allowed the deduction. The Sherman case is important because the taxpayer was a full-time, unemployed MBA student and his educational expenses were deductible because the court held that he was involved in a trade or business and was only temporarily away from it.

In Schneider (TC Memo 1983-753), the court ruled that Schneider’s duties as an Army officer did not constitute a trade or business and therefore his Harvard MBA qualified him for a new trade or business. Schneider argued that his position in the Army was that of a manager and his studies at Harvard improved his managerial skills. The court did not agree with this argument, stating that under this view nearly anyone could claim to be a manager in a trade or business. In the August 31, 2005, Allemeier Tax Court ruling, however, Justice Kroupa ruled that the taxpayer should have been allowed a tax deduction of over $15,000 in tuition-related expenses incurred in pursuing an MBA from Pepperdine University.

The Allemeier Tax Court Memorandum

Since 1996, Allemeier had been employed as a salesman by a laboratory that specializes in making removable orthodontic appliances. He was initially employed part-time, and became a full-time employee in 1997 after receiving a bachelor’s degree in sports medicine. Allemeier was initially hired to sell a single product; however, he performed very well in his position, and as a result his responsibilities increased to multiple products and services. In addition to selling, his increased duties included designing marketing strategies, organizing seminars, traveling to meet staff, and promoting various products. All these tasks were required by his position and performed prior to his obtaining an MBA degree.

Allemeier started his MBA studies at Pepperdine University in 1999 and finished in late 2001. Before enrolling in the MBA program, and before graduation, he had received several promotions. In these new positions, his duties steadily expanded to include such actions as analyzing financial reports and designing action plans for sales. Allemeier remained a full-time employee while pursuing the MBA degree.

Specific issues. Allemeier deducted $17,500 of tuition expenses as unreimbursed employee business expenses on his 2001 federal income tax return. The IRS (respondent) disallowed the deduction, and Allemeier filed a petition for relief in the U.S. Tax Court. The court specifically focused upon two of the now-well-examined criteria for this type of deduction: the minimum education requirement for promotion, and the qualification for a new trade or business.

The first issue examined by the court was whether the MBA was the minimum education requirement not for initial employment, but rather for promotion after initial hiring. The IRS argued that the MBA degree was not required for Allemeier to be initially hired, but was required for promotion. The evidence offered by the IRS centered around Allemeirer’s parallel enrollment in the MBA program and his advancements at work.

The second issue examined by the court was whether the MBA qualified Allemeier for a new trade or business. The IRS argued that Allemeier’s evolving duties and increased responsibilities after he enrolled in the MBA program demonstrated that he entered into a new trade or business. Prior to beginning the MBA program, Allemeier’s duties were primarily sales-related and involved minimal financial and managerial duties. After he entered the MBA program, he advanced to other jobs, and his duties involved advanced managerial, marketing, and financial tasks. The IRS argued that: “the MBA qualified petitioner for the specific new trade or business of ‘advanced marketing and finance management.’”

Deciding factors. On the first issue, of whether the MBA was a prerequisite to Allemeier’s being promoted, the court rejected the argument of the IRS. In the stated opinion of Judge Kroupa:

We find no evidence … that petitioner was required to begin the MBA program to receive the promotions at issue. … Encouraging petitioner to obtain the MBA and speculating that he might advance faster with the MBA is not tantamount to a requirement that petitioner obtain the MBA. … We decline to find that a minimum education requirement existed merely because petitioner’s promotions happened to coincide with his enrollment in the MBA program.

On the second issue, of whether the MBA qualified the petitioner for a new trade or business, the court also sided with Allemeier’s argument that the MBA merely enhanced and maintained skills already used in his job, and did not qualify him for a new trade or business or for any particular promotions. Allemeier further argued that the MBA improved the abilities he already possessed prior to entering the program. The court agreed, recognizing that Allemeier’s tasks prior to and after entering the MBA program involved the same types of duties:

Petitioner excelled in his duties and was rewarded with increased responsibility, including management, marketing, and finance-related tasks. The record establishes that he performed these myriad tasks before he enrolled in the MBA program. Once he enrolled, but before he finished the MBA program, he was promoted to new positions involving more complex tasks, but still involving the same marketing, finance, and management duties. … Simply acquiring new titles or abilities does not necessarily constitute the entry into a new trade or business program. … The MBA rather improved preexisting skills that petitioner used before enrolling in the MBA program.

The court also distinguished the MBA program from educational programs qualifying taxpayers for professional certification or license. Law school expenses have been consistently denied deductions because the taxpayer qualified for a new trade or business of being an attorney, even if the duties performed before and after the education were similar. Courts have also argued that a licensed public accountant is a different trade or business from a certified public accountant and that the educational expenses to become a CPA are not deductible [Glenn v. Comm’r (Dec. 32, 613) 62 T.C. 270. 275 (1974)]. The MBA did not lead Allemeier to qualify for a professional certification or license.

The primary characteristics of Allemeier and the three other cases discussed above are compared in Exhibit 2. (Galligan is not included because it did not involve an MBA program.) Several characteristics of Allemeier stand out. First, Allemeier received his MBA education part-time while being employed in a trade or business full-time. The MBA was not a requirement for the trade or business, nor was it required for promotion. Finally, Allemeier was involved in his trade or business before, during, and after his MBA training; Schneider and McEuen, however, were not. The court held that the MBA trained them for new trades or businesses.

Lessons from Allemeier

The Graduate Management Admission Council recently reported that, according to a special report by the U.S. Department of Education, two-thirds of domestic MBA students are enrolled in part-time or executive programs. These programs are growing much faster than traditional full-time programs. The majority of the students in part-time programs are employed full-time and may benefit significantly from the deductibility of education expenses. In determining whether educational expenses for an MBA are deductible, students and their tax advisors should consider the criteria used by Justice Kroupa in Allemeier:

• Allemeier was in a trade or business prior to, during, and after pursuing his MBA degree. He continued in the same trade or business while completing his MBA requirements. Remaining with the same employer may have been a positive factor in the decision and should be taken into account by present MBA students.
• The MBA was not required for the initial position or for subsequent promotions. The MBA degree was not a condition for continued employment. Allemeier was initially hired without the MBA degree; in fact, he was initially hired part-time without any degree and was hired full-time after completing a nonbusiness degree in sports medicine. His supervisor strongly recommended that he pursue the MBA degree, but it was not required for subsequent promotions. He was promoted prior to entering the MBA program and was promoted again while in the program. His specific academic business knowledge did not appear to be a major factor in his initial hiring or in his promotions. His sports medicine background appeared to be a factor in his initial hiring. Present MBA students should determine whether their present position or the position of their immediate supervisor requires an advanced business degree.
• The job requirements before and after entering the MBA program were not substantially different. Allemeier was initially hired as a salesperson and was promoted to more advanced but similar positions before entering the MBA program and while in the program. His trade or business was considered the same before, during, and after the MBA program. Current MBA students should examine whether their duties have changed significantly since beginning the MBA program or will change upon its completion.
• The MBA program was not a requirement for a professional certification or licensure. The MBA program is a general business program to prepare students for general business duties and not for certification. The education expenses of an MBA program concentrating on accounting and preparing students for the CPA exam would not be tax deductible because of the professional certification preparation feature. MBA students should determine whether professional certification (CPA, CMA, CIA, CFP) was a result of their graduate training.

MBA Students, Take Note

The number of students earning the MBA degree has grown significantly over the past decade, to over 110,000 in 2000, an increase of 46% from 1990. Presently there are over 2,000 graduate business programs offered by over 1,200 different institutions worldwide. Enrollments in part-time MBA programs comprise approximately two-thirds of all enrollments, and are also increasing, along with the costs of such programs (Gene J. Koprowski, “Will MBAs Seek New Certification?,” College Journal from the Wall Street Journal, Sept. 14, 2004). For example, the 2005–2007 total class program fees for the Weekend MBA program at Michigan State are $44,700 for in-state students, up from $42,700 for the 2004–2005 program (bus.msu.edu/wmba/). The executive MBA at University of California Irvine has a cost of $67,500 for the 2005–2006 class
(gsm.uci.edu/AcademicPrograms/ExecutiveMBA/). Part-time and executive MBA programs are growing in both popularity and cost.

The criteria used in Allemeier should be applicable to many part-time MBA students. The decision may be a means by which many current and future MBA students can decrease their out-of-pocket educational expenses.