HEALTH & WELFARE
JOURNAL of PENSION BENEFITS
ISSUES IN ADMINISTRATION, DESIGN, FUNDING, AND COMPLIANCE
Volume 29 • Number 4 • Summer 2022
The pandemic has left many employers struggling with ways to entice employees to stay with the company. Tuition Assistance is an appealing benefit but it comes with some drawbacks.
B y S h e r r i e B o u t w e l l a n d E v a n G I l l e r
Sherrie Boutwell is a founding partner of Boutwell Fay LLP and has focused a career of 30 plus years in the areas of employee benefits law and ERISA. She is a highly sought-after advisor, speaker, and writer on employee benefits topics and takes pride in bringing a practical and down-to-earth approach to resolving complex benefits issues involving qualified, nonqualified, and health and welfare plans.
Evan Giller has worked in the field of employee benefits law for over 30 years. He has extensive experience working with retirement plans on a wide variety of tax and ERISA issues, including plan design, administration, corrections, and fiduciary responsibility. He specializes in the retirement and deferred compensation plans of tax-exempt and governmental employers and has a particular focus on 403(b) and 457 plans.
One of the byproducts of the Covid–19 pandemic has been a record numbers of employees quitting their jobs in the so-called Great Resignation. According to statistics from the Bureau of Labor Statistics (BLS), an average of almost four million employees left their jobs each month in 2021, which is the highest average on record since the BLS began tracking this statistic. There are many reasons why individuals choose to terminate their employment, but it leaves employers grappling with the question of how to entice employees to remain employed. Enhancing the offering of employee benefits is one tool an employer can use to encourage its employees to stay on board.
Tuition assistance is an appealing benefit for many employees, but there is a potential drawback to the employer: An employee with new or additional credentials may want to leave after taking advantage of the benefit. Since tuition assistance can be an expensive benefit for employers, some want to protect themselves from employees who only want a free education and have no intention of staying with the organization. To try to ameliorate this problem, some employers will require employees to repay the benefit if they leave employment within a designated period of time after receiving the benefit. For example, an employer may require the employee to repay 100 percent of tuition assistance if she leaves within one year of receiving the benefit, and 50 percent if she leaves within two years.
The Internal Revenue Code (Code) and applicable regulations have a number of provisions that treat tuition payments from an employer to an employee as tax-free. Code section 127 authorizes the establishment of an Educational Assistance Program, which lets an employer with a qualifying plan provide up to $5,250 per year in educational assistance (as defined in Section 127(c)(1)) to employees on a tax-free basis. Code section 132 allows certain educational assistance amounts to be treated as a working condition fringe benefit, and consequently not taxable. [Treas. Regs. § 1.162-5] However, amounts of educational assistance that are not exempt from taxes due to a specific Code section are taxable.
What are the tax consequences to employees who receive a taxable tuition assistance amount from their employers subject to a repayment requirement, but who then leave employment and are required to repay all or a portion of the amount received?
The first question to address is whether a tuition assistance payment paid to an employee by an employer that includes a contingency that may require repayment is taxable in the year received. Alternatively, can it be treated as a loan, and that such payment establishes a debtor-creditor relationship between the employer and employee? The determination of whether a debtor-creditor relationship has been established depends, in part, upon whether the employee, at the time the payment is made, intends to pay the money back. [Anson Beaver, 55 TC 85 (October 20, 1970)]
There are a number of factors that the courts have used to determine whether a payment from an employer is a loan or compensation. One factor relevant to this discussion is whether the obligation to repay the debt is unconditional. The Tax Court, citing Fairchild v. Commissioner [462 F.2d 462 (5th Cir. 1970)] noted that, “It is well settled that in order to establish a valid debt the obligation to repay must be unconditional and not contingent on future events.” [Steven M. Nix, et al., TC Memo 1982-330] If the obligation to repay the tuition assistance payment is contingent on the employee not remaining employed for the requisite period of time, the tuition assistance benefit does not establish a debtor-creditor relationship and the amount is taxable to the employee in the year received. In the rare circumstance where an employer makes a loan to an employee with an unconditional obligation to repay at a market interest rate, there is no income tax on the making of the loan (but there could be if the loan is later forgiven or a below market interest rate is used).
Thus, when an employer provides a taxable tuition assistance benefit to an employee, it generally will be subject to all applicable tax and payroll withholding in the year received. If the employee is later obligated to pay back the tuition benefit to the employer due to failing to meet a contingency for keeping the benefit, the employee would be looking to recover the taxes that he/she paid. This is a relatively straightforward matter if the tuition benefit is being repaid in the same tax year as when it was received. In such a case, the amount of compensation can be reduced by the repayment and the withholding adjusted accordingly.
When the repayment is made in a year subsequent to the year received, the employee cannot simply request a corrected W-2 for the year in which the original payment was received. Instead, the employee must use the “claim of right” doctrine as set forth in Code section 1341. Under Section 1341, if: (1) an amount is included in gross income in a prior year because it appeared that the employee had an unrestricted right to the item; (2) a deduction is allowable in a subsequent year because it is determined that the employee did not have an unrestricted right to the income; and (3) the deduction is more than $3,000, then the employee can either take the deduction or a credit for the amount of tax previously paid on the income repaid, whichever provides a better result. [IRC § 1341(a)]
The Internal Revenue Service (IRS) sets out the requirements under Section 1341 in Publication 525. [Publication 525, Taxable and Non-Taxable Income (2021)] If the payment meets the criteria to qualify as a “claim of right,” the employee can deduct the payment as an itemized deduction on Schedule A (and not as a miscellaneous itemized deduction) if the amount was included in income at the time it was received under a claim of right. Alternatively, the employee can choose to take a tax credit for the year of repayment, if that results in a lower tax being paid. If Federal Insurance Contributions Act (FICA) taxes were deducted from the tuition assistance payment the employee is repay-ing, the employer can refund the excess amount to the employee. If the employer does not agree to provide a refund, the employee should ask for a statement from the employer indicating the amount overpaid, and then can file a claim for a refund.
Prior to the passage of the Tax Cut and Jobs Act (TCJA), repayment amounts under $3,000 were deductible as a miscellaneous itemized deduction, subject to the limitation that the amount exceeded 2 percent of the taxpayer’s adjusted gross income. The TCJA eliminated miscellaneous itemized deductions from 2018 through 2025. Therefore, if the amount being repaid is less than $3,000 in those years, the employee does not appear to be able to deduct the repayment of the tuition assistance in the year it is paid back. [Publication 525, Taxable and Non-Taxable Income (2021)] Employers might consider disclosing this eventuality to employees who are eligible
to receive a taxable tuition assistance benefit that includes a repayment contingency.
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Reprinted from Journal of Pension Benefits, Summer 2022, Volume 29, Number 4,
pages 59–60, with permission from Wolters Kluwer, New York, NY,