EDUCATIONAL ASSISTANCE FUNDS

Tamsen L. Leachman

Tax Treatment of Educational Assistance Funds

Q: Do education assistance funds provided to employees qualify as taxable income?

A: Yes and no. Education funds are not treated as income, so long as the funds are either a working condition fringe or are from an employer-provided education assistance program. Funds that do not meet these qualifications, or are provided through another source, such as a trust fund, must be treated as income, unless the award of funds is made by a committee external to the employer.

Tax Treatment of Employer-Provided Educational Funds

Generally, any money received by an employee from an employer is included as income, if the money is provided:

(1) as compensation for past, present, or future employment services;

(2) for services which are subject to the direction or supervisor of the employer; or

(3) to enable the individual to pursue studies or research primarily for the benefit of the employer.
 
Reg. ' 1.117-4(c)(1). Courses that increase an employee's effectiveness on the job have been determined to be primarily for the employer's benefit. Therefore, the money paid by an employer for courses that help employees discharge their job duties are not tax-free scholarships, and must be characterized as income to the employee. Rev. Rul. 76-71, 1976-1 CB 308.

The exceptions to this general rule arise where:

(1) the cost of such benefits qualifies as a working condition fringe; or

(2) the benefits are provided under an employer's educational assistance program.

RIA's Analysis of Federal Income Tax, H-2050. Therefore, unless one of these exceptions applies to an employer's educational assistance program, the funds should be characterized as income to the employees who receive them.

Working Condition Fringe

A working condition fringe is any property or services provided to the employee by his/her employer, including the payment of an employee's educational expenses, where:

(1) the educational expense was of a type that would have qualified as a deduction under Code Sec. 162 or 167 for the employee; and

(2) the subject of the education is related to the employee's trade or business.

Therefore, the funds used to pay for courses to maintain or improve an employee's job performance, such as continuing education-type classes will qualify as a working condition fringe. In such cases, the funds used to pay for these courses are not included as income to the employee. To the extent that an employer's educational assistance program has such restrictions in place, the funds distributed would probably qualify as a working condition fringe for tax treatment purposes.

Education Assistance Program

Employee educational expenses paid through an employer's qualified education assistance program are also not included in the employee's gross income. Code Sec. 127(a)(1). The employer-provided educational assistance exemption has recently been extended to include all covered educational expenses paid before May 31, 2000. 105 PL 34, 111 Stat. 788, HR 2014, Sec. 221.

1. Scope of a qualified education assistance program

The scope of a qualified education assistance program is defined by the type of educational expenses covered and the subject and level of courses permitted.

a. Type of permitted expenses

The following expenses, when paid through an employer's education assistance program, are not included as income to the employee:

(1) educational expenses paid by an employer and incurred by or on behalf of the employee, including, but not limited to, tuition, fees, books, supplies, and equipment; and

(2) courses of instruction provided by an employer for an employee, including books, supplies, and equipment.

Code Sec. 127(c)(1)(A), (B).

Some expenses, even when paid through an employer's education assistance program, must still be included as income to the employee. For example, an employer's payment for tools or supplies (other than textbooks) that an employee may retain after the course or instruction ends, meals, lodging, or transportation must be considered as income to the employee. Code Sec. 127(c)(1); Reg. ' 1.127-2(c)(3).

b. Course subject and level restrictions

An employer may pay for any form of instruction or training that improves or develops an individual's capabilities, whether or not job-related or part of a degree program under a qualified education assistance program without defeating the non-taxable status of the benefit supplied to the employee. The major limitation to this rule is with regard to graduate level course work. The non-taxable status of the educational benefit is lost if the course is at a graduate-level, and is of a kind normally taken by an individual pursuing a program leading to a law, business, medical or other advanced academic or professional degree. Conf. Rept. No. 104-737 (PL 104-188) p. 208.

2. Requirements for qualified education assistance programs

In order to be a qualified education assistance program, the following requirements must be met:

(1) It must be a separate written plan of the employer. The terms of the program must be included in a separate document providing only qualified educational assistance (see above);

(2) It must be for the exclusive benefit of employees of the employer, including retired, disabled, laid-off employees, or employees on leave;

(3) Eligible employees must be given reasonable notice of the program; and

(4) The program may not discriminate.

Code Sec. 127(b)(1), (6); Reg ' 1.127-2(b), (d).

Tax Treatment of Educational Funds from Other Sources

Scholarship or grant funds received by a candidate for a degree at an educational organization are not taxable to the student if the money received:

(1) does not represent compensation for services; and

(2) is used for qualified tuition and related expenses.

RIA's Analysis of Federal Income Tax, J-1230.

However, where the employer administers privately funded awards, they will qualify for tax-free treatment in only very limited circumstances. Indeed, the IRS has concluded that employer-administered, privately funded scholarships will be characterized as income to the employee, unless:

(1) the employer to recruit or retain employees does not use the scholarship program;

(2) the committee selecting the scholarship recipients is comprised of individuals totally independent of the employer;

(3) the scholarship program imposes identifiable minimum requirements for grant eligibility. These requirements must relate to the purpose of the program rather than to factors related to employment;

(4) selection of grant recipients is based solely on substantial objective standards that are completely unrelated to the employer's line of business, e.g., academic performance;

(5) the grant must not terminate if the recipient terminates his/her employment;

(6) the course of study is not limited to those of benefit to the employer;

(7) the terms of the grant must satisfy the requirements for qualifying scholarships under Code Sec. 117; and

(8) the program grants awards to a small percentage of the employees' children.

Rev. Proc. 76-47, Sec. 4.01-.08, 1976-2 CB 670.

Withholding Obligation of Employer

Q: Must an employer withhold taxes from educational assistance awards to employees that do not qualify for tax-free treatment?

A: Yes. If the educational assistance funds do not qualify for tax-free treatment, then they are subject to the same withholding rules as other forms of income.

Once it is determined that educational assistance funds are taxable as income to the employee, the employer must conduct the same income tax withholding undertaken for other forms of wages. RIA's Analysis of Federal Income Tax, H-4400. These obligations are summarized below.

1. Amount that must be withheld

An employer may treat non-exempt educational benefits as part of regular wages for the payroll period and compute withholding on the total, or, instead, treat these benefits as supplemental wages and withhold 20% of the value of these benefits from regular wages. Ann. 85-113, 1985-31, IRB 31; IR 85-70, 7/1/85.

2. Time to withhold and deposit taxes

An employer must withhold income tax as of the date or dates that the employer elects to treat such benefits as paid, and must deposit the withheld taxes and the employer taxes under the regular rules for tax deposits.

A reasonable estimate of the value of such benefit provided is sufficient to meet timely deposit requirements. The employer should estimate the value of such benefit provided on the selected date and calculate the income and employment taxes due based on that estimate.

If the value is underestimated and withholding taxes are under-deposited, a penalty may apply. An overestimate which results in an overpayment may be recoverable by applying for a refund or electing to apply the overpayment to the next quarterly return.

If an employer withholds too little from the employee, taxes may be recovered from the employee. The recovery must occur before April 1 of the following year. Ann. 85-113, 1985-31 IRB 31; IR 85-70, 7/19/85.

3. Reporting on the employees' W-2 form

The actual value provided during the calendar year must be determined, and reported on Form W-2 by January 31 of the following year. An employer may report the value of such benefits provided and the amount withheld either on the same Form W-2 that is used to report the employee's regular wage information, or on a separate form W-2. The total value of such benefits for the year must be noted in the appropriate box on the Form W-2. Ann. 85-113, 1985-113, IRB 31; IR 85-70, 7/19/85.

4. Reporting on the employer's quarterly report

Employers must report income tax withheld from wages, including such benefits, to the IRS on Form 941, the employer's quarterly federal tax return. The actual value of any such benefits provided during the calendar year must be determined and reported on the quarterly return for the period in which the benefit is treated as paid. Ann. 85-113, 1985-113, IRB 31; IR 85-70, 7/19/85.  

Improper Withholding

Q: What if the employer withheld social security and payroll taxes from educational assistance funds in 1997 in reliance on the prior law?

A: The employee will be entitled to reimbursement of the withheld amounts.

The IRS recently clarified that employers who provided withheld social security and payroll taxes from employee educational assistance funds should return the withheld amounts to employees. IRS Pub No. 508, p. 6, (1997). Employees who cannot obtain a direct refund from their employers should look to the IRS for the refund. Employees must: (1) file a Form 843 and (2) attach a statement from the employer listing any amount that paid to the employee as reimbursement, and the amount claimed by the employer. If such a statement cannot be not obtained, employees can still seek reimbursement by: (1) filing the Form 843; and (2) attaching an explanation of efforts made to obtain the employer's statement and an estimate (made to the best of the employees' knowledge and belief) of the information that would be in this statement. The employee should write "IRC 127" on the top margin of this statement to expedite the process.