Work Related Education Deduction
You may be able to deduct educational expenses paid during the year as a business expense, even if the education leads to a post-bachelor degree (MBA, etc.). However, because the deduction can be quite large and the rules are subject to varying interpretations, the IRS has increased its audits in this area.
To Qualify, you must meet 3 requirements:
What If I'm Audited?
If you are audited, it is likely that the IRS will question whether a) you still had a trade or business if you took time off for school, b) the education qualified you for a new trade or business and/or c) the education truly improved your skills in the trade or business you had before entering graduate school or if it should be considered personal enrichment and thus nondeductible. For the last item, they may look at specific coursework to see if it directly relates to your business.
Is James Available for Audit Help?
Yes, if you need me to advise or represent you in case of audit, my billing rate is $300 per hour.
Should I Claim the Deduction?
Since obtaining an MBA can be very costly, claiming a business deduction for it can be a great tax savings. The downside is that such a large deduction draws the attention of the IRS and in the past couple of years, the audit rate for education deductions has increased substantially. However, if you feel confident that you meet the criteria for claiming the deduction, the worst case is that your deduction is later disallowed and you have to pay back the tax you saved from claiming the deduction, plus interest and late penalties from the filing date. Whether or not to claim the deduction is really a personal choice based on the criteria above as well as your own level of risk tolerance. I cannot make the decision for you. I can provide you consulting on your personal situation, but the time would be billable.
When Must I Claim the Deduction?
The expenses must be deducted in the year you paid them. This includes costs paid using loan funds. If your income in that year is less than your deduction, you will generate a net operating loss which can be carried forward to reduce your taxable income in the next year. Net operating losses can be carried forward up to 20 years until used up.
What are the Chances of Being Audited?
Audit rates in general are low, but the risk for the work related education deduction seems moderate at this time. The higher your education expenses deducted in one year, especially if you have low or no income in that year, the greater the risk.
What Proof is Needed to Defend an Audit?
You should obtain a letter from your employer (pre and post MBA) stating that the education was a necessary to maintain or improve your skills. Make sure the employer does not state that the MBA is a standard requirement for your field (this could be construed by the IRS agent as a minimum requirement, and therefore making your education nondeductible). One IRS agent told me, "If the individual cannot establish that the MBA led to an improvement in her already-existing skills the Court will disallow the deduction." Also, proof of that the expenses were incurred will be requested. You should have receipts from the school's bursar's office, bookstore, etc. to substantiate the amounts claimed. Other possibilities could include a resume, a listing of courses taken, and details of duties in your jobs before and after school.
Where is the tuition deducted on my tax return?
On Schedule A as an Employee Business Expense (details on Form 2106) which is an itemized deduction subject to the 2% of AGI (adjusted gross income) floor for miscellaneous itemized deductions. The 2% floor means that you can deduct only the amount in excess of 2% of your adjusted gross income. Other limitations to itemized deductions may also apply and you can only take itemized deductions if they exceed the standard deduction.
For more information, see IRS Publication - Tax Benefits for Work Related Education.