A special provision in the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act)¹ signed by the President on March 27, 2020 allows employers to pay their employees’ student loans with pre-tax dollars up to a limit of $5,250.
Under the law pre-CARES Act, amounts paid by an employer toward the payment of an employee’s student loans generally are treated as additional taxable wages, and as such, are subject to federal income and employment taxes, withholding and reporting. Section 127 of the Internal Revenue Code (the “Code”) provides that gross income of an employee does not include amounts paid by an employer for education assistance so long as such amounts are paid under an educational assistance program satisfying the applicable requirements set out in the Code. The CARES Act amends the rules that govern educational assistance programs under Code section 127 to allow employers to pay eligible employees’ student loans (including principal and interest) as “educational assistance.”
Not all student loan payments qualify. The statute requires that the payments must be made by the employer on or after the date of enactment (March 27, 2020) and before January 1, 2021. The loan with respect to which the payments are made must have been incurred by the employee for the employee’s education. Loans taken out by a parent of the employee will not qualify. Neither will a loan for the education of an employee’s child. An employer may choose to make loan payments directly to the lender or to reimburse the employee for payments already made by the employee.
To qualify for exclusion from income, loan payments must represent principal or interest on a “qualified education loan,” as defined in Code Section 221(d)(1), which is the provision that allows individuals to deduct interest on student loans. In order to qualify as a qualified education loan,² section 221(d)(1) requires that the loan is taken out solely to pay “qualified higher education expenses,” which includes tuition and fees, room and board, books, supplies, equipment and other necessary expenses (such as transportation). However, section 127(c)(1) explicitly excludes a “payment for, or provision of, . . . meals, lodging, or transportation.” It is unclear whether the amount that is excludable from income under section 127 with respect to a payment on a qualified education loan has to be reduced to take into account that portion of the loan that may have been used to pay for meals, lodging or transportation. Further guidance on this point would be helpful.
A qualified education loan includes “indebtedness used to refinance indebtedness which qualifies as a qualified education loan.” Thus, a qualified education loan that has been refinanced will not result in the loan’s loss of its qualified status.
Section 127(c)(1)(B) added by the CARES Act provides that the loan payment must be paid on a loan “incurred by the employee for education of the employee.” Some practitioners have interpreted this language to require that the loan be incurred for education received while the employee is employed and not before the commencement of employment with the employer offering the program. This interpretation is based on the language of section 127(c)(1)(A), which also requires that educational assistance must be for “expenses incurred by or on behalf of an employee for education of the employee,” which has been interpreted to prohibit income exclusion for education received prior to the commencement of employment. It seems unlikely that Congress intended that this interpretation should be applied to student loan payments since a substantial portion of student loans incurred by employees would have been incurred before they became employed. Clarification on this issue could result in a substantial increase in the number of employees who can benefit from this income exclusion provision.
In order to take advantage of the new rule, an employer will need to establish an educational assistance program if it has not already done so. If the employer has an existing program in place, it will need to be amended to add student loan payments as a benefit under the program. The following is a description of the general requirements for an educational assistance program, and how these requirements might apply in the context of a program providing student loan repayments.
Exclusive Benefit of Employees. An educational assistance program must be established for the exclusive benefit of employees. However, within the definition of “employees” are self-employed persons including partners, sole proprietors, and more-than-2% Subchapter S shareholders.
Separate Written Plan. An educational assistance program must be established for the purpose of providing educational assistance. There must be a “separate written plan” that provides the terms of the program, and the benefits provided under the program must consist solely of educational assistance. Employers will want to specify in the plan document the class of employees who are eligible and the benefits that will be provided. In addition, employers should reserve the right to amend or terminate the program. Employers may choose to limit the benefits that are provided. For example, a program could provide that the sole benefit is the payment or reimbursement of student loans, provided that the class of employees who are eligible is nondiscriminatory. See paragraph 4 below. For a program that is limited to student loan repayments, the plan document should incorporate the requirement that all payments or reimbursements be made during the period beginning on the later of March 27, 2020 or the establishment of the program by the employer and ending December 31, 2020, in addition to the $5,250 dollar limit imposed under section 127.³ Another limitation that should be included in the plan document is the requirement imposed by section 127(b)(3) that no more than five percent of amounts paid under the program be provided to individuals who are owners who own more than five percent of the employer on any day of the year.⁴
Substantiation. Regulations provide that employees receiving benefits should “be prepared to provide substantiation to the employer such that it is reasonable to believe that payments or reimbursements made under the program constitute educational assistance.” Since employers must have a reasonable belief that a payment is nontaxable in order to avoid penalties for failure to withhold or pay employment taxes, the plan document should require some level of substantiation, although it is unclear what form that substantiation should take in the case of student loan repayments.
No Choice of Cash or Benefits. An employee must not be given the choice of receiving taxable compensation or educational assistance. For example, an employee cannot agree to a salary reduction in exchange for receiving a benefit under the program. This rule is applicable even if the agreement is not in writing. However, nothing would preclude an employer from providing educational assistance in lieu of payment of a discretionary bonus to which the employee has no legal right.
No Discrimination in Favor of Highly Compensated Employees. The program cannot benefit employees who qualify under a classification set up by the employer that is discriminatory in favor of highly compensated employees.⁵ A highly compensated employee for this purpose is determined in the same way as for 401(k) plan nondiscrimination testing. For 2020, an employee is highly compensated if he or she was a 5% owner at any time during 2019 or if the employee had compensation for 2019 in excess of $125,000. Regulations provide that employees are considered to benefit from the program if they are “actually eligible for educational assistance under the program, taking into account the eligibility requirements set forth in the written plan, the eligibility requirements reflected in the types of educational assistance available under the program, and any other conditions that may affect the availability of benefits under the program.” For example, a program that provides educational assistance only in the form of student loan repayments would benefit only those employees who actually have student loans.
Because an employer may not know which of its employees have student loans, without soliciting that information from employees, it may be difficult at best to test for discrimination.⁶ Compliance with nondiscrimination testing is key since if the program fails, all employees who benefit must include the dollar value of their benefits in gross income.
6. Employee Notification. Employees eligible for an educational assistance program must be given reasonable notice of the terms and availability of the program. No special form of disclosure is required. Often employers use the plan document to satisfy the notification requirement.
Employers who are interested in establishing an educational assistance program with student loan repayments should contact a Boutwell Fay attorney for further information.
¹ Section 2206 of the CARES Act.
² Other requirements for a qualified education loan a re: (a ) Qualified education expenses must be paid or incurred within a reasonable period of time before or after the employee takes out the loan. This requirement is satisfied automatically if qualified education expenses a re paid with the proceeds of a student loan that is pa rt of a federal post secondary education loan program. (b) The loan must be for education provided to an eligible student, meaning a student who is enrolled a t lea st half-time in a program lea ding to a degree, certificate, or other recognized educational credential.
³ Payments in excess of the statutory dollar limit or pa id outside the permitted time period must be included in the employee’s gross income.
⁴ Other discretionary limitations that an employer might consider for inclusion in the plan document are: (a ) a requirement that employees be employed for specified length of time before being eligible; (b) a limit based on the due date of the loan payment, for example, the plan might provide that only loan payments due after the effective date of the plan and before January 1, 2021 may be paid or reimbursed by the employer; (c) a requirement that a n employee repay amounts paid under the program if the employee terminates employment within a fixed period of time following the employer’s payment; (d) an overall dollar limit on a ll benefits paid under the program for a ll eligible employees.
⁵ Regulations provide that discrimination is tested under Code section 410(b)(1)(B) –the same test that applies for ta x-qualified retirement plans. Since the regulations were issued,the language of section 410(b)(1)(B) has been a mended, so it is unclear whether the current test now set out in section 410(b)(2)(A)(i) (the nondiscriminatory classification test) should be applied or the test that applied a t the time the regulations were issued (the fair cross-section test).
⁶ A particularly helpful provision in the regulations provides that a program is not discriminatory merely because “different types of education assistance available under the program are utilized to a greater degree by employees with respect to whom discrimination is prohibited than by other employees.”