If you want to attract and retain the cream-of-the crop of employees, you’re likely already aware that offering benefits as part of a compensation package is a necessity. Due to the costs involved, small employers in particular must choose carefully among the benefits available—you want to offer the benefits that employees value most while also being affordable. Benefits that cover employee educational costs can fit that bill. If administered correctly, a program paying for your employee’s education, work-related or not, is a tax-free benefit for them, and a business deduction for you.
Why would you want to pay for an employee’s education if it isn’t work-related? While providing benefits that assist employees in improving and maintaining skills for their job makes a lot of sense, it seems counter-intuitive to encourage employees to obtain education that may qualify them to leave your employ. While this reservation is valid, consider that many employees value the personal enhancement that continued education provides. Not all will see it as a chance to change careers at their employer’s expense. Fulfilled employees are happier employees who perform better and have increased loyalty to the employer who made this enrichment possible. And after all, isn’t that what employee benefits are all about?
Generally, there are two methods that you can use to offer educational benefits to your employees and obtain favorable tax treatment for all concerned:
- a payment/reimbursement arrangement or
- an educational assistance program
Which method is the right one for your business and your employees depends mainly on whether the education qualifies as work-related.
Paying or reimbursing employees for work-related education
Reimbursing or paying for employees’ expenses for work-related education is a great way to add to your employees’ skills and knowledge, which they can then apply to help make your business a success. And for employers, the amount paid or reimbursed for an employee’s education expenses is a deductible business expense. As an added bonus, if the educational expenses qualify, employees may be able to exclude the payment or reimbursement from gross income as what is known as a working condition fringe benefit. Let’s look at what’s required to qualify for this tax break.
Tax-free treatment for employees. For employees to receive tax-free treatment for the payment or reimbursement, the education must meet at least one of the two following tests making it work-related:
- The education is legally required in order for the employee to keep his or her present salary, status or job.
- The education improves or maintains skills that are required in the employee’s present employment.
Conversely, an employee can’t exclude educational expense payments or reimbursements from income if either of the following applies:
- The education is required for the employee to meet the minimum qualifying educational requirements of his or her present trade or business or employment.
- The education qualifies the employee for a new trade or business.
Warning
An employee doesn’t necessarily have to go into a new trade or business for the payment or reimbursement to be taxable. Even where an employee continues to work for you in the same capacity, if the education qualifies the employee for a new trade or business, the payment or reimbursement is not excluded from income.
Finally, only payments or reimbursements made under the requirements of an accountable plan can be excluded from an employee’s income. The requirements of an accountable plan include the following:
- The education expenses paid or reimbursed are work-related.
- The employee receiving the benefit adequately accounts for the expenses to the employer.
- Excess payments are returned to the employer.
Tip
If the payment or reimbursement isn’t made under an accountable plan, an employee may be able to claim job-related educational expenses as a miscellaneous itemized deduction on his or her income tax return. However, it is not excluded from gross income and is compensation subject to withholding and payroll taxes.
It’s important to note that even if a payment or reimbursement is considered compensation, an employee can still derive a cost benefit from employer-paid educational expenses. The benefit is that the employee is paying only the tax on the amount paid by the employer, while the employer is paying the entire amount of the educational expense included in compensation.
What types of educational expenses qualify for exclusion from an employee’s income? They include:
- tuition
- lab fees
- books
- supplies
- certain transportation costs
- certain travel costs
Educational assistance programs for educational expenses
Employers who wish to offer employees tax-free benefits for educational expenses, regardless of whether the expenses are job-related, can do so by using an educational assistance program.
Educational assistance programs allow employers to provide employees with educational assistance of up to $5,250 annually excluded from an employee’s income. Employers can claim a business deduction for educational employee benefits paid and are not required to pay FICA or FUTA payroll taxes for benefits provided under the program.
Because of its all-inclusive nature, the definition of educational assistance is best explained by what it excludes. Exclusions are generally limited to:
- certain instruction involving sports, games or hobbies
- meals, lodging and transportation
- tools and supplies an employee can keep after completing a course
Written plan and notice to employees. How do you qualify your payments for employee educational expenses as an educational assistance program? The IRS requires you to create a separate written plan for the educational assistance benefits. The plan must fulfill the following requirements:
- The plan must provide educational assistance-related benefits. Educational assistance is defined as:
- the payment of expenses incurred by employees for education (including tuition and fees and books, as well as certain supplies and equipment)
- courses of instruction which employers provide for employees
- The plan cannot allow employees to choose between educational assistance and other payments that are included in employees’ gross income, for example, cash.
- The plan may not give educational assistance benefits to employees’ spouses or dependents.
- The plan cannot discriminate in favor of employees who are officers, owners or highly compensated, or their spouses or dependents who are employees. The rule is that five percent or less of the educational assistance paid annually by an employer may be provided for the owners of more than five percent of the business or their spouses or dependents.
Tip
The nondiscrimination requirement does not mean that you must offer educational assistance to all your employees. You are free to cover only certain classes of employees as long as by doing so you don’t discriminate in favor of the employees listed above.
You are also required to give your eligible employees “reasonable notice” of the plan. However, what constitutes reasonable notice is not defined by the IRS or by the applicable laws. To cover yourself, make sure you provide the specifics of your plan in writing to your eligible employees.
Payments in excess of annual limits. What happens if you provide an employee with more than the $5,250 allowed by the educational assistance program? As the employer, you may deduct the entire amount that you pay for the employee's educational costs as a business expense. However, only $5,250 is not considered wages and therefore, not subject to payroll taxes. Amounts over the annual limit are subject to income and payroll taxes. As for employees, they must treat the amounts over $5,250 as income, unless these amounts qualify for exclusion from income as work-related education or are deductible as job-related educational expenditures.
Placing conditions on employee educational benefits
If you choose to offer your employees educational benefits, you may place conditions on the reimbursement or payment of the expenses. Some popular options include completing coursework with a passing grade, requiring a certain letter grade, or requiring an employee to continue to work for you for a specific length of time after you provide educational benefits.
It is tempting to impose conditions on the educational benefits you provide, particularly where they are not work-related. Exercise caution, however, because the value of an employee benefit can be diminished significantly if its use is undermined by over-severe restrictions. Keep in mind, too, that by choosing to provide educational benefits, you’re sending the positive message that you consider your employees motivated and invested in bettering themselves, both personally and professionally.
