Congress has provided a number of tax incentives to encourage employers to provide employee education. This article discusses one of the most overlooked employer education tax incentive, Section 127 plans.

Section 127 allows employers to create a program for providing employee education (up to $5,250 per year per employee), while permitting the employer a deduction and allowing the employees to exclude the 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.

An experienced tax attorney can help employers establish Section 127 Plans.

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IRS Tax Attorney Kreig Mitchell is a Denver tax lawyer whose practice is limited to resolving state and IRS tax troubles, including IRS audits, IRS levies and liens, IRS wage garnishments, offer in compromises, and IRS negotiations. Mr. Mitchell can be reached at 303.521.0053.

Adrian Singer is an Internet Consultant with http://www.SoftwareProjects.com