The nation’s student loan debt amounts to $1.3 trillion. Unfortunately, many students finish college with crushing debt without the gainful employment needed to pay off the debt. In some cases, student loans may be discharged or paid off by another party.
When debt is forgiven, the amount forgiven is generally taxable income to the borrower.
Fortunately, there are a few special provisions that help students avoid paying tax on discharged student loans.
Excluding Debt Forgiveness in General
There are two primary provisions that allow taxpayers to exclude debt forgiveness from taxable income:
• When the taxpayer is insolvent (i.e., the taxpayer’s total liabilities exceed her total assets), debt discharge income is excludable to the extent of the taxpayer’s insolvency (see example below)
• When the taxpayer’s debt is discharged through bankruptcy, debt discharge income is fully excluded from taxable income
Example: Joan has $100,000 in student loan debt and is unable to find a job in her profession. The student loan is her total debt and the value of all her assets is $25,000. To determine insolvency, Joan’s total assets ($25,000) are subtracted from her total liabilities ($100,000) and Joan’s insolvency is $75,000. Therefore, Joan can exclude $75,000 from taxable income. She must pay tax on the remaining $25,000 of debt forgiveness.
Example 2: Same facts as above except that Joan’s student loan is forgiven through bankruptcy (incredibly difficult to do). Since the student loan was discharged in bankruptcy, the full $100,000 discharged is not taxable.
Special Provisions for Student Loan Forgiveness
Tax Exclusion if Student Loan is Forgiven When Student Works in Certain Professions
Congress enacted a special rule that excludes student loan debt forgiveness from taxable income if the student works for a certain period of time in certain professions and for any of a broad class of employers. Congress enacted this special rule for certain student loans to encourage students to go into such occupations as medicine, nursing, and teaching in rural and low-income areas.
Department of Education Student Loan Discharges
The Education Department can use at least a couple procedures to discharge federal student loans.
Under the Closed School discharge process, the department can discharge a student loan when the student was attending a school at the time it closed or if the student withdrew within a certain period before the closing date. Student loans discharged under this program are excludable from taxable income.
Under the Defense to Repayment discharge process, the Education Department is required to discharge a federal Direct Loan if a student establishes, as a defense to repayment, that the school’s actions would give rise to a cause of action (lawsuit) against the school under state law. Student loans forgiven under this program are taxable unless the student qualifies under the insolvency or bankruptcy exceptions described above.
In 2015, the IRS ruled that students who took out student loans to finance attendance at a school owned by Corinthian Colleges, Inc. (eg, Everest, Everest University Online, Everest College Phoenix, Heald College, WyoTech) are able to exclude student loan debt forgiveness if the student loan was discharged under either the Closed School discharge process or the Defense to Repayment discharge process. This relief helps students whose student loans were discharged under the Defense to Repayment provision by not requiring them to prove insolvency or file for bankruptcy.
When Student Loans are Paid by an Employer
When an employer pays a student loan for an employee, it is taxable compensation to the employee. Simple enough.
To see how this applies to you, give us a call at 248-538-5331.
There are two primary methods for business owners to provide tax-free educational assistance to themselves and to their employees. The methods are:
- Working Condition Fringe Benefit
- Section 127 Plan
Working Condition Fringe Benefit
Educational expenses paid under this method are deductible by the employer and are tax free to the employee. The educational expenses are also excluded from payroll taxes such as FICA and FUTA. There is no limit on the amount of educational expenses that qualify; however, the educational expenses must be ordinary and necessary business expenses.
To qualify as a working condition fringe benefit, the educational program must relate to maintaining or improving the skills required by the employee’s job. The education itself must NOT lead to the student qualifying for a new trade or business. Education required to meet the minimum skill level required for the job does NOT qualify. Job related education may be furnished directly by the employer or through a third party such as an educational institution or seminar organization. The educational expenses of the business owner also qualify.
Example: ABC Corp employees Joan as an engineer. Joan is climbing the corporate ladder and believes an MBA will help her develop management skills to help her advance her career. ABC Corp pays for her MBA. Since the MBA will improve her skills, the educational expenses paid by ABC Corp will not be taxable to her. In addition, ABC Corp can take a deduction for the educational expenses.
Example 2: John is a law student working in a law firm as a legal assistant. The law firm offers to pay John’s law school tuition. These expenses will NOT qualify as a working condition fringe benefit because the law degree is required for John to meet the minimum requirements for his job as an attorney. However, the tuition may qualify for exclusion as a Section 127 plan.
Section 127 Plan
A Section 127 plan is a qualified education assistance program. The first $5,250 of qualified educational assistance provided during the year is exempt from tax, including FICA and FUTA.
To qualify under Section 127, a plan is required. The plan must:
- Be in writing
- Provide educational assistance exclusively to employees (possibly including owners)
- Not provide employees with a choice of education assistance and taxable compensation
- Provide reasonable notice of the availability and terms of the program
- Not discriminate in favor of highly compensated employees or their dependents
- Not pay more than 5% of the benefits to more-than-5% owners or their spouses or dependents
Children of owners can participate in a Section 127 plan if they are at least 21 years of age, are legitimate employees, are not more than 5% owners, and are not dependents of the owner. Children under age 21 can still participate in Section 127 plans, but their educational expenses are subject to the nondiscrimination rules (which could disqualify the plan).
Example: ABC Corp is owned by John. ABC Corp has three employees—Adam (John’s son) and two unrelated employees. All employees are 22 years old. John does not claim Adam as a dependent. ABC Corp pays $5,000 towards each employee’s tuition. Since Adam is at least 21 years old, is a legitimate employee, is not a dependent, and is not a more-than-5% owner, the tuition paid on his behalf is not counted as being for a highly compensated employee or a more than 5% owner. All employees may exclude the $5,000 tuition payment from their incomes.
Example 2: Same facts as above except that Adam (John’s son) is 20 years old. Since Adam is under age 21, he is attributed ownership from his father (i.e., Adam is considered a 100% owner). Since 33% of the benefits ($5,000 tuition for Adam divided by $15,000 total tuition paid) are paid for a more-than-5% owner, EACH employee must report the $5,000 tuition payment as income.
Key Difference between a Working Condition Fringe Benefit and Section 127 Plans:
- A $5,250 cap applies to Section 127 Plans, but not working condition fringe benefits
- If over $5,250 is spent on educational expenses under a Section 127 plan, the excess may qualify as a working condition fringe benefit
- The cost of travel, meals, and lodging may qualify as a working condition fringe benefit but not under a Section 127 plan
- The working condition fringe benefit is not subject to nondiscrimination rules
- The limitation on expenses that qualify a student for a new job or to meet minimum eligibility requirements will not qualify as a working condition fringe benefit, but may qualify under a Section 127 plan.
These rules are fairly complex. If you need help navigating through these rules, give us a call and we’ll be happy to help.
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Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230