Uncle Sam's Surprise For Grad Students

You may be due a tax refund, but the breaks are vanishing

Whether you are considering going back to college or have attended school recently thanks to an employer-paid education program, the Internal Revenue Service has a surprise for you. If you have taken advantage of your company's offer of educational assistance in 1995, you may be due a tax refund. However, if you are thinking about studying for an MBA or other graduate degree with the help of your employer, you no longer qualify for a big tax break.

For years, some 90% of major corporations have offered their workforce financial help for education and have received a tax write-off for doing so, according to Jerry Lanoux, a principal with Buck Consultants in Boston. Until the end of 1994, employees could receive up to $5,250, tax-free, to cover the cost of graduate and undergraduate education.

But on Dec. 31, 1994, the educational assistance provision in the federal tax code expired. Caught up in the congressional budget fiasco, the tax-favored status of educational benefits was put on hold for nearly two years. Unsure whether Congress would reinstate the tax exclusion, most employers withheld income and Social Security taxes on those benefits just to be safe, says Mark Kersting, a tax principal with the New York accounting firm of Urbach, Kahn & Werlin.

DRY WELL? Now, as part of the Small Business Job Protection Act, up to $5,250 in employer-sponsored education benefits are once again tax-free. The bad news is that graduate-level courses that began after June 30, 1996, are not included. Indeed, it is likely that many companies will stop offering any sort of financial assistance for graduate education, since the benefit will be less attractive to both employee and employer, which will have the administrative hassle of employment tax and reporting obligations.

Since the tax exclusion is extended retroactively, any employee who had taxes withheld last year on employer-sponsored education benefits, including graduate-level courses, is eligible for a refund. For workers in the top tax bracket of 39.6%, this can translate into a $2,100 windfall for each year of school, says Sam Mawn-Mahlau, a tax attorney at Peabody & Arnold in Boston. Even those who fall into the 28% bracket are eligible for a potential refund of $1,800 for taxes paid in 1995.

If your employer withheld taxes on these benefits in 1995, you'll need to file an amended tax return on Form 1040X in order to receive a refund. You can obtain the document from the IRS. To recalculate your tax, ask your employer for a revised W-2 form, or W-2c. Then compare the taxable wages on your original W-2 with your W-2c. Employees with more than $100,000 in adjusted gross income should also recalculate their allowable itemized deductions, Kersting suggests. That's because any reduction in gross income from taxes already paid on educational benefits will increase the amount of deductions you are allowed by a small amount.

In addition to income taxes, your employer likely withheld Social Security. The company will receive a refund, which should be passed on to you in your regular paycheck. However, it is a good idea to check with your benefits office to confirm that you will be reimbursed for Social Security taxes paid. If you are unable to obtain a refund from your employer because you have left the job or the company has gone under, you'll need to file Form 843, also available from the IRS, for a direct refund. And if state taxes were paid on the benefits, you must also file an amended state return, which is obtainable from your state taxing authority.

DO IT NOW. The aggravation of filing numerous forms is tempered by the fact that the IRS has established an expedited service to process them. To ensure a speedier refund, you must write "IRC Section 127" across the top of all federal tax forms. Technically, you have three years from the date you sent in your original return to amend it, but experts suggest refiling in the next few months.

Employers also will need to take action. All educational assistance plans must be amended to eliminate graduate-level courses as a tax-free benefit. "If companies are not in compliance and the benefits are disqualified, there can be tremendous costs for both the employer and employee in the event of an IRS audit," says Mawn-Mahlau.

All this recalculating and refiling probably seems onerous. But think of it as good practice. As of May 31, 1997, the tax break will expire once more. If Congress does not react quickly enough, you may find yourself repeating the whole process in two years.

Before it's here, it's on the Bloomberg Terminal.