Earning an MBA is an expensive process, with students spending upwards of $65,000 on tuition alone at the top-five full-time MBA programs in BusinessWeek's 2002 rankings. But many graduate students (and even some companies that help MBAs pay their tuition) don't know all the ins and outs of legally maximizing their deductions when they file tax returns each April.
To learn more about smart tax strategies for MBAs, BusinessWeek Online turned to James C. Vonachen, CPA and partner at Clifton Gunderson in Denver. Every tax season, Vonachen's office processes more than 2,300 individual tax returns and 500 business and related entity-tax returns. He's also an MBA himself, having received his business degree from Notre Dame in 1973, followed by a law degree in 1974. He earned his accounting degree at St. Joseph's College in Indiana.
Vonachen recently spoke with BusinessWeek Online reporter Mica Schneider. Here's an edited transcript of their discussion.
Q: What's the most common tax break graduate students pursue?
A: The Lifetime Learning Credit. It's is a dollar-for-dollar credit against tax. This credit is figured at 20% of your qualified educational expenses [often limited to tuition expenses] and is not to exceed $2,000. So if you have $10,000 in tuition expenses, you reach the maximum $2,000 credit.
You won't get this credit if you've earned between $85,000 and $105,000 as a married couple filing jointly in 2004, with the credit starting to phase out after you reach $85,000. Single individuals' income cut-off ranges from $42,000 to $52,000.
Q: MBAs degrees cost a lot more than $10,000 these days. Should MBAs use the Lifetime Learning Credit anyway?
A: Yes, that's the first one you'd want to use up.
Q: And the next credit to use?
A: You may also qualify for the Deduction for Higher Education Expenses, which you're entitled to for tuition and related expenses paid to accredited post-secondary institutions. It also has income cut-offs. If you're married and filing jointly, and [jointly] earning more than $130,000, you're not entitled. If you're single, the limit is $65,000. All other taxpayers aren't offered this benefit. The maximum deduction is $4,000.
Q: It seems that married graduate students should file jointly.
A: To get the majority of these educational benefits, that's correct. You have to do your best guess on numbers, put your pencil to it, but you're not required to think about that until you file your tax return.
Q: What's a common list of school expenses MBAs can deduct? Should they hold onto receipts each time they purchase an accounting book?
A: It depends. Under the Lifetime Learning Credit, books and fees don't qualify as deductions. But under the Deduction for Higher Education Expenses, books and fees do qualify. Some of your independent costs, such as Internet connections, don't qualify under the Lifetime Learning Credit, but they do under the Deduction for Higher Education Expenses.
Q: Can MBAs apply for both deductions?
A: No. One student cannot claim both deductions. However, if a husband and wife are filing jointly, and both are students, then the wife might claim the Lifetime Learning Credit and the husband might claim the Educational Expense Deduction.
Q: MBAs may also save some money listing miscellaneous itemized deductions, right?
A: When you file your tax returns, you're allowed to claim certain categories of expenditures, such as medical expenses, taxes paid, charitable contributions, and unreimbursed business expenses. When you add up all of your itemized expenses across all the categories and it exceeds your standard deduction, which ranges from $4,750 to $9,500, then you can qualify for an extra deduction by itemizing. But these expense limits may change next year.
Q: MBAs usually plan to deduct the interest from their often hefty student loans. Is that a deduction they should rely on?
A: That's one of those deductions you think you get, but you may not qualify for because of its relatively low gross-income limit, about $50,000 to 65,000 for single individuals and $130,000 for married individuals filing jointly. If you're married and filing separately, you can't claim any of the loan interest as a deduction. Beyond those income caps, the [loan-interest] deduction gets phased out. After your MBA, you may find that your income is too high.
Q: Such student-loan deductions could stand to be quite large...
A: They could very well be. It's not unusual to see $20,000 to $25,000 per year worth of principle amounts borrowed for education. You can't get a deduction for the principle of the loan, but if you get a deduction on the interest of the loan, it can help. If you borrow privately, you could be paying 6% to 7% in interest and perhaps also have some undergraduate loans left to pay off. In that case, you could see deductions as high as $7,000 per year in the early years of the loan. There's no cap right now on the interest you can deduct so long as you meet the income qualifications.
Q: Students who plan to return to school in late August or early September often wonder when they should quit their jobs. Should they earn a bit more pocket money and finish work a few days before classes begin? Or should they quit before they make so much money that they don't qualify for deductions?
A: They stand to lose a $4,000 deduction. Someone at that level, probably in the 20% tax bracket [federal and state tax combined], is probably looking at losing about $800. They have to ask, "How much is the $800 loss of tax savings going to hurt me, vs. a full salary?" If you're making $40,000 in gross income, keep working.
Q: What's the best tax strategy for students whose income is too high for them to qualify for the tax credits?
A: If your employer isn't going to pay for it, you may be able to set up your own consulting business. That makes you your own employer. As long as the requirements are met that you're improving your position and not moving into a new business, then you can deduct all of the expenses related to going back to school, such as buying books, paying tuition, and travel costs. If you need a new computer, that's a business expense. If you need a DSL line, that's a business expense.
You have to show some gross income, and that's the hard part. It's not going to pass the smell test if you say you're a consultant but you've only got expenses. You also have to show how hard you've tried to develop income. Have you sent solicitation letters? Have you had business meetings to develop relationships? A lot of people have signed on as a consultant or independent contractor with their former employers, with their former employer paying for work on some specific projects.
Q: Can you classify a summer internship as a consulting gig?
A: Probably not. If you get a W-2 form from your employer, you won't qualify as an independent consultant.
Q: How would someone set up as a consultant?
A: One way is to form a limited liability company, or an S corporation (which tends to provide the same liability protection as an LLC). All you really need to do is show that you've got a 1099 form at the end of the year. That's proof-positive that you're an independent contractor and in the consulting business.
Q: When is a good time to get in touch with an accountant if you're thinking about going back to school?
A: You want to get a strategy and know what your options are. If you want to go the consulting route, you want to be setting that up six-to-nine months ahead of time to support the fact that you're in the business. It's part of financial planning that says, "What's the true cost of this education, and what can I do to reduce this cost?" If you wait too late, you may have missed some opportunities.
Q: What other tips do you offer MBAs returning to school?
A: The old-fashioned way, your fallback, is that these expenses -- tuition, books, transportation costs -- can fall under the miscellaneous itemized deductions if you meet the requirements on reimbursed employee business expenses but were never reimbursed by your employer. Also, you must have incurred the cost while you were working. With that category deduction, you lose 2% of those deductions toward your adjusted gross income.
Q: What advice do you have for employers who are considering paying for an employee's MBA?
A: As long as the course doesn't qualify the individual for a new trade or business and is a course that enhances the skills that they already have, then it's tax-deductible for the employer on a straight, outright basis. So if a boss spends $10,000 to send Jane to business school, they'll get a $10,000 deduction against the company's gross income.
The employer deduction can happen in one of two ways. Section 127 is a qualified educational reimbursement program but has to meet a lot of IRS requirements, including a written plan and information about the company's nondiscrimination process. That's wide open, as far as what courses can be taken [though you can't take sports-related classes].
Option two, Section 162, says an employer can pay for its employees' education provided that the courses are job-related and treated as an ordinary and necessary business expense. Typically, if employees are going back for an MBA, they've already met the minimum requirements for a job, so they're clearly in a position of enhancing their knowledge and helping the employer.
Q: It seems like option two is way to go for employers...
A: It's absolutely the way to go, and it's so simple that a lot of employers forget about it. One of the nice things about it is that the employer can put restrictions on the employee contract that says, for instance, "We'll only reimburse your education if you plan to stick with the company for another two years, or if you earn a certain grade-point average."
Q: Some students are lucky enough to attend business school for free. Either their employer foots the bill or they receive scholarships. Are these MBAs eligible for school-related tax deductions?
A: If they're 100%-funded by their employer, they're not eligible for any [deductions]. Scholarships are generally tax-free, but if a portion of the scholarship covers room and board, it will be treated as taxable income. If a portion covers fees, that may or may not be taxable.
Q: If a student doesn't have an accountant, are there any books you'd suggest turning to for some early number-crunching?
A: I'd suggest two IRS publications. Publication 970, Tax Benefits for Education, and Publication 520, Scholarships and Fellowships. Both give a thorough analysis of the type of educational benefits available.
Q: Any final words of wisdom for MBAs?
A: What may be a tax benefit for one person may not be the same for his neighbor. It all depends on personal circumstances. Some things that will change your benefits include your income level, your filing status (married/single), age, occupation, and your status as an employee.
Are you an employee or an independent contractor? Know what you have to do in order to qualify for certain deductions. If you know that your income level is $65,000, a cutoff for a deduction, see if you can push some of that income into the next year, and you may get the benefit of a deduction in the current year.