Paul L. Caron

Monday, July 10, 2023

Lesson From The Tax Court: Deducting Graduate School Costs

Camp (2021)My desire to become a law professor crystalized during the four years I practiced law after my judicial clerkship.  My academic mentors told me it would be very difficult to get a job in the legal academy because I had been “contaminated” by ... wait for it ... wait for it ... actually practicing law!  They told me I needed to “recommit” myself to academia by going back to law school to get a graduate law degree, called an LLM (for Master of Laws).

So I went to Columbia.  It was not cheap.  As I packed up my office to go back to school, I remember discussing the tax implication with my boss at that time, John Quinn.  John remains one of the attorneys I most deeply admire and respect.  He still practices at his firm Quinn, Racusin & Gazzola.  John and I debated whether I could, or should, deduct the costs of my LLM.  His concern was that because the LLM seemed to qualify me for a new trade or business—being a law professor—its expenses would not be deductible.  He advised me not to attempt a deduction.  I did not follow that advice.  And I got audited.  More on that at the end of this post.

Today we learn why John’s concern was well-founded.  In Ariana K. Uchinzozo v. Commissioner, T.C. Summ. Op. 2023-21 (Judge Carluzzo), we learn that the cost of an MBA is not deductible under §162 when it gives the taxpayer skills for entry into a new business, even if the MBA is not a formal requirement for that new business.  In today's case the taxpayer started a part-time MBA program in 2014 while working for a translation services company.  She deducted her MBA expenses on her 2014 return.  Through her MBA program she got an internship with Mattel and, eventually, a job.  And even though her Mattel job did not require an MBA,  the Tax Court still held she was not entitled to deduct the costs of the MBA because the skills she was learning enabled her to enter a different trade or business than the one she was in the year she took the deduction, 2014.  Details below the fold.

Law: Deducting Education Expenses Under §162 
Section 162(a) permits taxpayers to deduct “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business....”  That can include the costs of certain education.

To deduct education expenses under §162 a taxpayer must meet one of two “must” requirements and must avoid both of two “must not” barriers.  The regulations explain.

First, Treas. Reg. 1.162-5(a) gives us the two “must” requirements.  The education must either (1) maintain or improve the taxpayer’s skills in their current trade of business or (2) be required to stay employed or keep an established status, such as a licensed professional.

The first “must” can be a bit tricky.  It recognizes “that education is both "ordinary and necessary" within the meaning of the statute if it is customary for other established members of the taxpayer's trade or business to undertake such education.”  Carlucci v. Commissioner, 37 T.C. 695, 700 (1962).  The tricky part, however, is that the education must have a sufficiently close relationship to the employment that the taxpayer is currently engaged in.  For example, it would be very unusual for the cost of a college degree to be deductible.  Almost always that is for the simple reason that few undergrads are carrying on a trade or business while going to college.  But even those that are have a difficult time showing the needed relationship. See Carroll v. Commissioner, 51 T.C. 213 (1968)(Denying deduction for costs of policeman’s undergraduate education because “there is only a remote relationship between the study of Shakespeare's plays and the petitioner's work as a policeman.”).  Similarly, if a taxpayer pursues a graduate degree that is not related to their current employment, they will not meet this requirement. See Zhang v. Commissioner, T.C. Summ. Op. 2003-58 (taxpayer’s MBA was not sufficiently connected to his employment as an engineer to meet this first “must” requirements).

As you can see, this is a very fact-intensive inquiry.

The second “must” requirement is pretty straightforward.  It is what permits lawyers, CPA’s and Enrolled Agents to deduct the costs of the continuing professional education they must obtain each year in order to keep their various statuses.  See Treas. Reg. 1.162-5(b)(3)(ii), Example 3.

Second, Treas. Reg. 1.162-5(b) gives us two “must nots" that will bar a deduction.  The education must not either (1) meet the minimum requirements for employment in the taxpayer’s trade, or business, or (2) qualify the taxpayer for a new trade or business.  It's that second barrier that seems to be the more common problem.

For example, students who complete law school and obtain a J.D. cannot deduct the costs of law school because the J.D. degree qualifies them to sit for the Bar Examination and to become a lawyer. This is so even they have no intention of becoming a lawyer but simply went to law school to improve their skills in another type of business, such as financial planning or accounting.  See Treas. Reg. 1.162-5(b)(3)(ii), Examples 1 & 2.  For another example, see Thompson v. Commissioner, T.C. Memo. 2007-174 (2007) (costs of flight school were not deductible, even though the education improved taxpayer’s ability as an aeronautical engineer, because completion of the flight school resulted in a commercial pilot’s license).

Many folks think that if the education does not qualify one for a new trade or business, then it will not run into the buzz-kill of Treas. Reg. 1.162-5(b).  Nope.  Even if the education does not qualify the taxpayer for a new trade or business it will still be non-deductible if it is done primarily for advancement or promotion in the same line of work.  The Tax Court put it this way: the “cost of education undertaken primarily for the purpose of obtaining a new position or substantial advancement in position ... does not constitute deductible ordinary and necessary business expense.” Carlucci v. Commissioner, 37 T.C. 695, 700 (1962).

Once a taxpayer meets one of the “must” requirements, and avoids both of the “must not” barriers, then all costs reasonably related to the education are deductible.  That means not only tuition but also transportation, room, and board, subject (of course) to the applicable restrictions in evil §274.  But not all of §274 applies.  For example, while §274(m)(2) disallows deductions for costs of travel as education (think the high school French teacher spending summers in France to improve language skills), the costs of travel for qualifying education is deductible.  See Jorgensen v. Commissioner, T.C. Memo 2000-128 (high school English teacher allowed deduction for expenses to travel to Europe and Asia for summer courses sponsored by University of California that directly related to her teaching).

Enough with the law.  Let’s look at the facts and learn our lesson.

Ms. Jorgensen graduated from college in 2012 with a double major in Spanish and French.  In the year at issue, 2014, she was working for a California company called Inline Translation Services (ITS).  The company’s business was providing written translations to customers.  On the website I linked above, the company says “We use a multistep process for our projects that ensures thorough, accurate, and complete translation. We always work with native speaking professional translators with degrees in translation and relevant certifications.”

It appears that ITS hired Ms. Jorgensen to work on translation projects.  Natch.  As I read her job description, reprinted in the opinion, she was basically a project manager.  But it was a small company (this website says 4 employees, but this “our team” page from ITS says there are 5 project managers).  Thus her job description, reprinted in the Opinion, lists a wide range of both high-level and low-level cradle to grave tasks, from handling customer inquiries and creating price quotes and written proposals, to selecting and managing translation project teams, to formatting final documents, managing desktop publishing, proofreading, and billing.  She was “also responsible for managing the budget for each of her projects.” Op. at 2.

In 2014 Ms. Jorgensen started a part-time MBA program at UCLA.  While ITS reimbursed its employees for foreign language classes, it did not do that for business classes.  So Ms. Jorgensen deducted the costs of the MBA on her 2014 tax return as an unreimbursed employee expenses on Schedule A.  That’s back before Congress got all grinchy in §67(g).

In 2016 Ms. Jorgensen left ITS to take a summer internship at Mattel as part of her MBA program.  That turned into a full-time job in the fall of 2016 as a consumer insight analyst.  She finished up her MBA in 2017.

The IRS audited Ms. Jorgensen’s 2014 return and disallowed her deductions for her MBA expenses that year.

Lesson: Education Must Relate To The Job You Have, Not The Job You Want
To deduct her MBA expenses for 2014, Ms. Jorgenson needed to connect that education to her work at ITS, because that was the trade or business she was carrying on in 2014.  Judge Carluzzo explains that the Court “uses a ‘commonsense approach’ comparing the tasks and activities the taxpayer was qualified to perform before acquiring the degree at issue with those the taxpayer was qualified to perform afterwards.”  Op. at 4.

She could not make the connection. ”The courses petitioner took as part of her M.B.A. program qualified her to perform tasks that were significantly different from the tasks she had performed in her employment with [ITS]. ***  No doubt some of the courses might have refined and improved the skills necessary for petitioner’s employment with Inline, insofar as a foundation in accounting, finance, and management could be helpful to anyone involved in the operation of a business. However, petitioner’s M.B.A. studies were more specifically oriented towards the job for which she eventually left Inline.”  Op. at 5.

Thus, the proper connection was not between her MBA and the job she had in 2014.  It was between the MBA and the job she wanted to have—and later obtained—at Mattel.  Judge Carluzzo sees the Mattel employment as a separate trade or business than the ITS employment.  That is, while Ms. Jorgensen seemed to do similar work—project management—at both companies, the big difference was that at Mattel she was in charge of research projects, not translation projects.  Different line of business.

The Mattel job required her to organize “qualitative and quantitative research projects, including product development, brand strategy, communication, tracking, and usability research for Mattel brands..” Op. at 3.  Therefore, Judge Carluzzo concludes, “petitioner’s data and analysis coursework prepared her to perform her essential role with Mattel .... Simply put, without the M.B.A. degree petitioner would not have been otherwise qualified for her position with Mattel. Op. at 5.

So no deduction in 2014.  And same for 2015, but that year is now closed.  However, note that 2016 was when Ms. Jorgensen began working for Mattel, first as an intern and then as a permanent hire.  As Judge Carluzzo notes, that would not have happened but for her participation in the MBA program, even though Mattel did not require an MBA degree.  So it seems that for 2016 and 2017 Ms. Jorgensen would indeed be entitled to deduct her MBA expenses because once she started working for Mattel, those courses became relevant to improving her job skills.  Of course all of that is academic since those are now closed years.  But it's still a lesson and, remember, I am an academic.

Coda 1:  The Rest of My Story:  I received my LLM from Columbia in May 1993 and returned to D.C.  But I could not get a job in legal academia.  So that fall I started work at the IRS Office of Chief Counsel.  While it was a great job, I still wanted to teach and so kept on applying and writing articles to show my "commitment."  After another eight years of applications and interviews, I finally found a school foolish enough to hire me: Texas Tech.  It turns out that Texas Tech actually valued (and still does value) folks who have real world lawyering experience.  Phew.

Coda 2:  About That Audit:  My 1992 return was selected for audit and not just because I was now an IRS employee.  Yes, at that time every IRS employee’s returns were reviewed for the 3 years before their hire date.  But my 1992 return triggered the red-alert system because I claimed education expense deductions that totally wiped out my 1992 income from Quinn, Racusin & Gazzola.  And I had also attached a letter to the return flagging the issue.

John Quinn's concern was shared by the Revenue Agent.  She looked closely at the relationship between the LLM and my employment as a lawyer.  I was able to convince her that I met the “must” requirement of enhancing my job skills as a practicing lawyer at the IRS, even though my LLM was not a Tax LLM!  I was also able to convince her that the LLM did not qualify me for the new trade or business of teaching law.  So I dodged the "must nots."  Had she found a deficiency, however, I would have petitioned the Tax Court.  And I may not have fared any better than Ms. Jorgensen if I had had to appear before Judge Carluzzo!

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) for another Lesson From The Tax Court.  


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@ Jerry: LOL. Yes, 67(g) sucks. But even without it, I think deducting MBA costs is more difficult than LLM costs.

Posted by: bryan | Jul 10, 2023 2:47:46 PM

Great job, as always, Bryan. I started to look into this more for my son who just got an MBA at your alma mater but then realized no misc. itemized deductions. Damn 2017 Tax Act and GOP.

Posted by: Jerry Borison | Jul 10, 2023 2:35:55 PM

I'm a USTCP and represented in Tax Court an MBA candidate where I was able to deduct the courses that related to the MBA, except for two courses not related to the current occupation. We won! It was my very first Tax Court case after being admitted.

Posted by: Lorry Sorgman | Jul 10, 2023 9:53:27 AM

I worked for IRS for 31 years as a Revenue Agent. I attended night school while working for the IRS. I was already a CPA when I went to night school. I earned three additional degrees in Accounting and Taxation. I deducted all of my tuition and books since it improved my skills as a Revenue Agent. I was never audited.

Posted by: Michael A. Talbert | Jul 10, 2023 5:43:33 AM

superb commentary.TY

Posted by: jean paul buffon | Jul 10, 2023 4:03:54 AM

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