Tax-Free Education Benefits For Law Firm Employees

Law firms can provide a valuable fringe benefit for their employees by paying for their education costs. There are several ways a firm can choose to provide this benefit, and depending on the circumstances, one way may be more valuable than another. In addition, the different ways of providing the benefit are not mutually exclusive, and can be mixed and matched to provide greater benefits than one method might provide.

The different ways of providing the benefit are:

• Scholarships and grants under IRC '117;
• Education assistance programs under '127; and
• Working condition fringe benefits under '132.

Each way will provide tax-free education benefits to the firm's employees, provided the specific criteria of each code section is met.

Scholarships and Grants

Scholarships and grants under '117 must meet two criteria to ensure non-taxability. They are:

• The scholarship must be used for “qualified tuition and related expenses”; and
• The student must be a degree candidate at a qualified education institution.

“Related expenses” include tuition, enrollment fees, books, supplies and equipment required for courses of instruction. Other expenses such as travel, room and board are excluded. Any scholarship not utilized for qualified expenses is taxable to the student.

The employer can offer the scholarship not only to the employee, but to the spouse and children as well. Care must be exercised, however, not to link the scholarship with past, present or future employment services. Failure to do so would subject the employee to taxable income. The same outcome would occur if the education of the student employee was shown to be primarily for the employer's benefit.

To avoid this result, law firms can establish private foundations to offer scholarships, and have these foundations select the recipients and handle disbursements. As long as the scholarships are awarded on an objective and nondiscriminatory basis, and comply with foundation requirements, the scholarship will not be taxable.

Education Assistance Programs

Education assistance programs under '127 allow annual education benefits of up to $5,250 per employee. However, unlike scholarships and grants under '117, spouses and dependents are not covered. The benefit can be used for both graduate and non-graduate courses. Similar to scholarships and grants, “education assistance” is restricted to direct educational costs such as tuition, fees, books, supplies and equipment (travel room and board are excluded).

There is no requirement, however, for the student to be a degree candidate as under '117, nor does the education have to be job-related as in working condition fringe benefits (see below).

The major drawback to '127 plans is that they can be quite costly and burdensome for employers to administer. They require annual tax return filings (Form 5500) and a formal written plan with reasonable notice to eligible employees. They also may not be discriminatory in favor of highly compensated employees, and not more than 5% of the program's benefits can be allocated to partners. However, these plans are flexible with respect to setting their own eligibility requirements, such as limiting benefits to post-graduate education only. For example, a recent IRS letter ruling allowed a law firm to provide all non lawyer employees up to a $5250 annual reimbursement for principal and interest on their law school student loans. Another feature is that there is no annual funding requirement. A cash-strapped company can put the plan on hold if need be until cash flow improves.

Working Condition Fringe Benefits

Perhaps the best alternative in terms of ease of implementation and flexibility is the working condition fringe benefit under '132. The only requirement for excludability from the employee's gross income is that the benefit be related to a cost that would be deductible as an “ordinary and necessary” business expense. Under the Internal Revenue Service Regulations, these would include not only direct education expenses, but also travel, meals and lodging incurred in order to obtain education. In addition, working condition fringe benefits do not have the other disadvantages of scholarships and grants and education assistance plans discussed above. Thus, there is no maximum monetary limit, it may be discriminatory with respect to the type of employees covered (no spouses or dependents, however), and it may include partners. No written plan is required, nor are there annual filings. Also, the student employee does not have to be a degree candidate.

The only drawback with respect to this way of funding education expenses is that the expenses must be job related. Pursuant to regulations, they must either maintain or improve existing job skills or meet the express requirements necessary for the employee to remain in his or her current position. If these criteria are not met, these expenses will be taxable to the employee. Establishing a link between the education and current job requirements may involve reviewing and perhaps updating job descriptions so that they present a more accurate and complete list of skills required for the position.

Conclusion

Law firms have several ways of offering tax-free education benefits to their employees. As previously discussed, these ways may be mixed and matched to best accomplish both the employees' and firm's goals. However, law firms should consult with a tax adviser knowledgeable in the various ways of funding educational benefits to ensure non-taxability.

Law firms can provide a valuable fringe benefit for their employees by paying for their education costs. There are several ways a firm can choose to provide this benefit, and depending on the circumstances, one way may be more valuable than another. In addition, the different ways of providing the benefit are not mutually exclusive, and can be mixed and matched to provide greater benefits than one method might provide.

The different ways of providing the benefit are:

• Scholarships and grants under IRC '117;
• Education assistance programs under '127; and
• Working condition fringe benefits under '132.

Each way will provide tax-free education benefits to the firm's employees, provided the specific criteria of each code section is met.

Scholarships and Grants

Scholarships and grants under '117 must meet two criteria to ensure non-taxability. They are:

• The scholarship must be used for “qualified tuition and related expenses”; and
• The student must be a degree candidate at a qualified education institution.

“Related expenses” include tuition, enrollment fees, books, supplies and equipment required for courses of instruction. Other expenses such as travel, room and board are excluded. Any scholarship not utilized for qualified expenses is taxable to the student.

The employer can offer the scholarship not only to the employee, but to the spouse and children as well. Care must be exercised, however, not to link the scholarship with past, present or future employment services. Failure to do so would subject the employee to taxable income. The same outcome would occur if the education of the student employee was shown to be primarily for the employer's benefit.

To avoid this result, law firms can establish private foundations to offer scholarships, and have these foundations select the recipients and handle disbursements. As long as the scholarships are awarded on an objective and nondiscriminatory basis, and comply with foundation requirements, the scholarship will not be taxable.

Education Assistance Programs

Education assistance programs under '127 allow annual education benefits of up to $5,250 per employee. However, unlike scholarships and grants under '117, spouses and dependents are not covered. The benefit can be used for both graduate and non-graduate courses. Similar to scholarships and grants, “education assistance” is restricted to direct educational costs such as tuition, fees, books, supplies and equipment (travel room and board are excluded).

There is no requirement, however, for the student to be a degree candidate as under '117, nor does the education have to be job-related as in working condition fringe benefits (see below).

The major drawback to '127 plans is that they can be quite costly and burdensome for employers to administer. They require annual tax return filings (Form 5500) and a formal written plan with reasonable notice to eligible employees. They also may not be discriminatory in favor of highly compensated employees, and not more than 5% of the program's benefits can be allocated to partners. However, these plans are flexible with respect to setting their own eligibility requirements, such as limiting benefits to post-graduate education only. For example, a recent IRS letter ruling allowed a law firm to provide all non lawyer employees up to a $5250 annual reimbursement for principal and interest on their law school student loans. Another feature is that there is no annual funding requirement. A cash-strapped company can put the plan on hold if need be until cash flow improves.

Working Condition Fringe Benefits

Perhaps the best alternative in terms of ease of implementation and flexibility is the working condition fringe benefit under '132. The only requirement for excludability from the employee's gross income is that the benefit be related to a cost that would be deductible as an “ordinary and necessary” business expense. Under the Internal Revenue Service Regulations, these would include not only direct education expenses, but also travel, meals and lodging incurred in order to obtain education. In addition, working condition fringe benefits do not have the other disadvantages of scholarships and grants and education assistance plans discussed above. Thus, there is no maximum monetary limit, it may be discriminatory with respect to the type of employees covered (no spouses or dependents, however), and it may include partners. No written plan is required, nor are there annual filings. Also, the student employee does not have to be a degree candidate.

The only drawback with respect to this way of funding education expenses is that the expenses must be job related. Pursuant to regulations, they must either maintain or improve existing job skills or meet the express requirements necessary for the employee to remain in his or her current position. If these criteria are not met, these expenses will be taxable to the employee. Establishing a link between the education and current job requirements may involve reviewing and perhaps updating job descriptions so that they present a more accurate and complete list of skills required for the position.

Conclusion

Law firms have several ways of offering tax-free education benefits to their employees. As previously discussed, these ways may be mixed and matched to best accomplish both the employees' and firm's goals. However, law firms should consult with a tax adviser knowledgeable in the various ways of funding educational benefits to ensure non-taxability.