IRS issues guidance on education tax incentives.

The IRS recently issued Notice 97-60, which provides guidance on the higher education tax incentives enacted as part of the Taxpayer Relief Act of 1997 (TRA '97). After a brief introductory discussion, the Service elaborated, in question and answer format, on each of the seven new education tax incentives introduced by the TRA '97. Provided below is a brief summary of each incentive followed by some of the more important issues outlined in the notice. (For further analysis and a table listing the various education opportunities and benefits, see Bukofsky and Sherr, "Diverse Planning Opportunities Available Under the TRA '97 (Part II)," this issue, page 108.)

Hope Scholarship Credit 

The Hope Scholarship Credit (Hope credit) is a nonrefundable tax credit up to $1,500 per student for qualified tuition and related expenses paid by the taxpayer. The student must be enrolled within one of the first two years of a post-secondary degree or certificate program at an eligible educational institution on at least a half-time basis.

The Hope credit is available for expenses paid after Dec. 31, 1997, for education furnished in academic periods beginning after such date. The allowable credit is phased out ratably for single taxpayers with modified adjusted gross income (AGI) between $40,000 and $50,000 and married taxpayers with modified AGI between $80,000 and $100,000.

Sec. 25A(f)(1) defines "qualified tuition and related expenses" for purposes of the Hope credit as tuition and fees required for the enrollment or attendance of the taxpayer, the taxpayer's spouse or any dependent of the taxpayer. The TRA '97 specifically excluded from the definition expenditures for books, meals, lodging, student activity fees, athletic fees, or similar personal or extracurricular activity expenses.

The notice clarified the following items with respect to the Hope credit:

* "Qualified tuition and related expenses" do not include room and board.

* Qualified tuition and related expenses paid with tax-free assistance (e.g., a Pell Grant, other tax-free scholarships, a tax-free distribution from an individual retirement account (IRA), or tax-free employer-provided education assistance) are not taken into account in calculating the credit amount. Qualified expenses not paid with tax-free assistance (e.g., loan proceeds, personal savings, etc.) are eligible for the credit.

* Although the credit is available only for qualified payments in an academic period beginning in the same calendar year as the payment is made, an exception allows advance payments to cover academic periods beginning in January, February or March of the following tax year. However, it is important to note that, since the Hope credit applies only to qualified expenses paid after Dec. 31, 1997, tuition paid in 1997 to cover 1998 academic periods does not fall within this exception.

* Although the credit could normally be claimed by either a parent or a student, only a student may claim the Hope credit in a year in which the student takes a tax-free withdrawal from an Education IRA. Moreover, the student cannot claim the credit in the year in which a tax-free withdrawal from an IRA occurs, unless the student waives the tax-free treatment of the Education IRA distribution to claim the credit.

* Either the parent or the child, but not both, may claim the credit for the child's expenses in a particular year. If an individual claims the child as a dependent on his Federal income tax return for the year, only that individual may claim the Hope credit. If no one claims the child as a dependent on a Federal income tax return for the year, only the child may claim the credit.

* Because the Hope credit is not effective until 1998, guidance on how to claim and calculate the credit will be provided with the instructions accompanying the 1998 tax forms for returns required to be filed in 1999.

Lifetime Learning Credit 

The Lifetime Learning Credit (Learning credit) provides a taxpayer with a credit equal to 20% of up to the first $5,000 of "qualified tuition and expenses" paid after June 30, 1998, providing a maximum credit equal to $1,000. For expenditures incurred after the year 2002, an additional $5,000 becomes eligible for the credit, allowing a taxpayer a maximum Learning credit equal to $2,000 (20% x $10,000). The Learning credit is more expansive than the Hope credit, because it covers post-secondary education at the graduate level as well as at the undergraduate level. In addition, this credit is available for students enrolled at qualified educational institutions to acquire or improve job skills. The same AGI phaseout rules that apply to the Hope credit also apply to the Learning credit.

The Learning credit differs from the Hope credit in that the Learning credit is calculated on a per-family basis and does not vary based on the number of students in the taxpayer's family, while the Hope credit is calculated on a per-student basis.

The notice clarified the following items with respect to the Learning credit:

* Unlike the Hope credit, students are not required to be enrolled at least half-time in one of the first two years of post-secondary education. Accordingly, the Learning credit is available for a student taking only a single course at a qualified educational institution.

* Although both credits may be claimed by a taxpayer in the same year, only one of the credits may be claimed for a particular student in any given year. A family with two students can claim different credits for each.

* As with the Hope credit, qualified tuition and related expenses for a student (who is not claimed as a dependent on anyone's Federal income tax return) must not be paid for with tax-free assistance (e.g., a Pell Grant or other tax-free scholarship, a tax-free distribution from an Education IRA or tax-free employer-provided educational assistance).

* Although the credit is available only for qualified payments in an academic period beginning in the same calendar year as the payments are made, an exception allows advance payments to cover academic periods beginning in January, February or March of the following tax year. However, advance tuition payments made before the July 1, 1998 effective date to cover academic periods beginning before or after that date are not eligible for the Learning Credit.

* A student's expenses in a single tax year may be used as the basis for either the Hope credit or the Learning credit, but not both.

Education IRAs

For years beginning in 1998, taxpayers may deposit up to $500 per year into an Education IRA for a child under age 18. The taxpayer contributing to the child's Education IRA may be a friend, family member or the child himself. Amounts deposited in an Education IRA grow tax-free until distributed and the child will not owe tax on withdrawals from the account, if the child's qualified higher education expenses at an eligible institution for the year are at least equal to the amount withdrawn. Excess withdrawals are generally subject to both an income tax and an excise tax.

Although modified AGI limitations apply to the contributing individual, these limitations are relatively high ($95,000-$110,000 for singles; $150,000-$160,000 for joint filers), compared to the credit limitations previously discussed. Moreover, efforts are being made to increase the $500 annual contribution limitation. Accordingly, the Education IRA becomes particularly attractive to a wider group of taxpayers.

The notice clarified the following items with respect to the Education IRA:

* "Qualified higher education expenses" include room and board.

* Rather than rolling over money from one Education IRA to another, the designated beneficiary of an account may be changed from one child to another without triggering a tax. (Note: The particular trust or custodial account must permit the change.)

* Contributions may not be made to both a Qualified State Tuition Program and an Education IRA on behalf of the same designated beneficiary in the same tax year.

* Although parents, grandparents, friends and even a child himself may contribute to the child's Education IRA(s), the total contribution for the child during the tax year cannot exceed the $500 limit. It should be noted that a parent or grandparent with excess AGI can give the money to the child, who could then make the contribution to his own Education IRA.

* The designated beneficiary may take a tax-free withdrawal to pay higher education expenses, even if the beneficiary is enrolled at an eligible institution on a less-than-half-time basis.

* Assets that remain undistributed in an Education IRA after a designated beneficiary finishes his post-secondary education can be rolled over to another Education IRA for the benefit of another member of the designated beneficiary's family.

Using IRA Withdrawals to Pay Higher Education Expenses

Beginning in 1998, a taxpayer may make withdrawals from an IRA to pay qualified higher education expenses for the taxpayer, the taxpayer's spouse, or the child or grandchild of the taxpayer or taxpayer's spouse, at an eligible educational institution. Although income tax will be owed on the amount withdrawn, the taxpayer will not be subject to the 10% early withdrawal penalty when amounts are withdrawn before the account holder reaches age 59 1/2.

The notice clarified the following items with respect to these IRA withdrawals:

* For purposes of these rules, "qualified higher education expenses" are defined to include tuition, fees, books, supplies and equipment required for the enrollment or the attendance of the student at the eligible educational institution. This includes room and board if the student is enrolled at least half-time.

* An "eligible educational institution" is defined to include any college, university, vocational school or other post-secondary educational institution described in Section 481 of the Higher Education Act of 1965 (20 U.S.C. 1088).

* A taxpayer may take a withdrawal from a Roth IRA (as he can from any other IRA) to pay qualified higher education expenses without incurring the 10% early withdrawal penalty.

Student Loan Interest Deduction 

Beginning in 1998, taxpayers who have taken loans to pay the cost of attending an eligible educational institution for themselves, their spouses or their dependents generally may deduct interest they pay on these student loans. The maximum deduction each taxpayer is entitled to increases in $500 annual increments from $1,000 in 1998 to $2,500 in the year 2001 and thereafter. The deduction is available for interest payments made on or after Jan. 1, 1998, and only applies to interest payments required during the first 60 months in which the loan is repaid. Income restrictions phase out the deduction for taxpayers with AGI in excess of $40,000 and $60,000, for single and married taxpayers, respectively.

The notice clarified the following items with respect to the student loan interest deduction:

* The loan must have been used to pay the "cost of attendance" at the eligible educational institution. The "cost of attendance" includes tuition, fees, room and board, equipment and other necessary expenses (such as transportation).

* The deduction is available for interest paid on loans used to pay for graduate school.

* A former student continuing repayment of a loan on or after Jan. 1, 1998 is eligible for the interest deduction, but must count the months before Jan. 1, 1998 that interest payments were required against the 60-month time limit.

* The student loan interest deduction is available for student loans not Federally guaranteed or otherwise subsidized.

* Parent(s) may claim the student loan interest deduction if the parent(s) borrow the money in a year in which the parent(s) supplies more than half of the student's support.

Expanded Qualified State Tuition Programs

A Qualified State Tuition Program (QSTP) is a program established and maintained by a state under which a person may (1) prepay tuition benefits on behalf of a beneficiary so that the beneficiary is entitled to a waiver or a payment of qualified higher education expenses or (2) contribute to an account established for paying qualified higher education expenses of a beneficiary. The tax on the earnings attributable to the prepayments or the contributions are deferred until the earnings are distributed from the QSTP. The beneficiary pays tax on the earnings at the time of the distribution.

The notice clarified the following items with respect to QSTPs:

* If amounts saved through a QSTP are used to pay for college, the student or the student's parents may claim the Hope credit or the Learning credit for qualified tuition and related expenses.

* QSTPs may now be used to pay expenses not only at public and nonprofit institutions, but also at any school eligible for the Hope Scholarship or Lifetime Learning Credits.

* Accounts in QSTPs may now be transferred tax-free from the beneficiary to a broader range of family members (step-siblings and spouses of family members are now included).

No amounts may be contributed to an Education IRA on behalf of a designated beneficiary in the same year an amount is also contributed to a QSTP.

Extended Exclusion for Employer-Provided Education

The TRA '97 extended the tax-free treatment to recipients of up to $5,250 per year in employer-provided educational assistance for undergraduate courses that begin before June 1, 2000.

The notice clarified the following items with respect to the employer-provided education exclusion:

* A student cannot claim a Hope credit or Learning credit for expenditures paid for with employer-provided educational assistance.

* The employer should treat the educational assistance as a tax-free benefit; no requirement exists to include it on the employee's W-2.

* Although an employee may not receive tax-free educational assistance from the employer to attend graduate school, employers can provide job-related educational assistance as a tax-free fringe benefit, if it maintains or improves skills required for the employee's current job or satisfies certain express employer-imposed conditions for continued employment.

From Randy A. Schwartzman, CPA, Melville, N.Y.