Regardless of how the so-called fiscal cliff is “resolved” – and whether this occurs before the end of 2012 – the expiration of educational assistance and adoption assistance tax provisions at the end of this year is already causing headaches for employers who provide (or hope to provide) their employees with these tax-advantaged benefits. However, employers can take some steps now to mitigate the uncertainty of whether these tax benefits will be retained or shelved for 2013 and beyond.
Under current law, an employee may exclude from income in 2012 an employer’s (or for educational assistance, a former employer’s) reimbursement or payment of:
- up to $5,250 of qualified educational expenses (e.g., tuition, fees, books); and
- up to $12,650 of qualifying adoption expenses (e.g., adoption fees, attorney fees, court costs, travel expenses, and re-adoption expenses).
The tax provisions allowing both of these exclusions expire at the end of 2012, and, despite their popularity among employers and employees alike (not to mention bipartisan Congressional support), it is unlikely that Congress will extend them on more than a temporary basis apart from a larger deal addressing the fiscal cliff and the ongoing tax reform debate.
As a result, employers who offer these benefits are left in an uncomfortable position. More than once in the 1990s, Congress missed the deadline for extending these provisions, allowing them to expire. However, each time, Congress reauthorized the provisions retroactively and allowed qualified payments made in the interim (after expiration and before reauthorization) to qualify for exclusion.
But even a retroactive fix raises complications:
- Until Congress reauthorizes the provisions, the IRS probably will expect employers to comply with tax withholding and reporting as if the payments were taxable.
- Changing the taxable status of payments already made by the employer could raise the need for FICA tax refunds or changes to the amounts of compensation-based retirement benefits, and could affect an employee’s eligibility for income-based benefits (like the earned income tax credit or limits on IRA or Roth IRA contributions).
- The retroactive fix likely would not apply for employers who have not yet adopted a qualifying plan: some employers are (understandably) in a holding pattern, not wanting to adopt a plan that will have associated administrative costs but no tax benefit. If an employer adopts a plan only after a retroactive reauthorization of the provisions, the plan might not be permitted to reimburse employees for expenses that they incur before the plan was adopted.
- The retroactive fix might be narrower than the current exclusion (for example, educational benefits might not apply to graduate-level courses).
- A retroactive fix might not apply to state income tax liability.
Despite all this uncertainty, there are a number of things that employers can do to help mitigate the problems surrounding the loss of the education assistance and adoption assistance exclusions:
- Some – but not all – educational benefits might qualify for exclusion as a working condition fringe benefit. Employers might wish to review their plans and application forms to ensure that they can rely on this exclusion as much as possible.
- Employers will want to ensure that they explain the tax treatment of educational and adoption assistance payments in the appropriate plan disclosure materials, and that they are prepared to address employee questions about the tax issues that will arise if the exclusions expire.
- If the exclusions expire, information about existing (and non-expiring) credits and deductions for education and adoption expenses may be of greater interest to employees, and employers can review their disclosures to include or revise references to these other tax benefits. However, employers should be careful in providing these explanations because, while employees may be eligible for both an exclusion and a credit or deduction in one year, they cannot get the benefit of both with respect to the same expenses. Accordingly, a retroactive reauthorization of the exclusions could cause some employees to lose their ability to claim a credit or deduction, at least for some of the expenses.
We will continue to monitor these issues and provide updates as the situation unfolds.