Background. Many churches operate schools and offer "tuition discounts" to employees of both the school and church whose children attend the school. For example, a church operates a private school (K-12). The annual tuition is $2,500. The school allows the children of its employees to attend at "half" tuition. The same rate applies to the children of church employees. For 2002, tuition reductions are provided to the children of 5 school employees, and 4 church employees. Are there tax consequences to these tuition discounts? Do the tuition "reductions" represent taxable income to the parents, or are they nontaxable? If they are nontaxable, what conditions apply?
Section 117(d) of the tax code specifies that "qualified tuition reductions" are not taxable. To be "qualified," however, certain conditions must be met. These include the following:
(1) The tuition reduction is provided to an employee of an "organization described in section 170(b)(1)(A)(ii)" of the tax code. This section refers to "an educational organization which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on."
(2) The qualified tuition reduction must be provided to a current school employee; a former school employee who retired or became disabled; or, a dependent child of a school employee.
(3) "Highly compensated employees" cannot exclude qualified tuition reductions from their gross income unless the same benefit "is available on substantially similar terms" to non-highly compensated employees. For 2002, the term "highly compensated employee" refers to any employee whose annual compensation for 2001 was $90,000 or more. The fact that a highly compensated employee must report the value of a tuition reduction in his or her income for tax reporting purposes does not affect the right of employees who are not highly compensated to exclude the value of tuition reductions from their income.
Church employees. Many churches that operate private schools offer tuition discounts to employees of both the church and school, and assume that the tax treatment is the same. But is it? Does the exclusion of qualified tuition reductions from a school employee's taxable income apply to church employees? As noted above, section 117(d) defines a qualified tuition reduction as "any reduction in tuition provided to an employee of an organization described in section 170(b)(1)(A)(ii) for the education (below the graduate level) at such organization." Section 170(b)(1)(A)(ii) refers to educational institutions that "normally maintain a regular faculty and curriculum and normally have a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on." In other words, tuition reductions granted to the employees of an educational institution are tax exempt.
In the past, it has not been clear whether the IRS or the courts would consider an employee who works directly for a church to be an employee of an educational institution, even if the church operates a private school. Your author has taken the position for the past few years in the annual Church & Clergy Tax Guide that tuition reductions provided to the children of church employees are not qualified and therefore should be reported as a taxable fringe benefit. This conclusion was based on two considerations: (1) A church is a religious rather than an educational institution. (2) A qualified tuition reduction must be provided by an educational institution described in section 170(b)(1)(A)(ii) of the tax code. This section is preceded by section 170(b)(1)(A)(i) which refers to "churches" as a separate category. This makes it difficult to argue that employees of a church described in section 170(b)(1)(A)(i) are eligible for an exclusion that is limited to employees of schools described in section 170(b)(1)(A)(ii).
The IRS provides clarification. A recent IRS ruling addressed the eligibility of church employees for qualified tuition reductions, and concluded that they are not eligible for the exclusion. IRS Private Letter Ruling 200149030. The IRS noted that nontaxable qualified tuition reductions must be provided by an educational organization described in section 170(b)(1)(A)(ii), which refers to schools.
The IRS conceded, however, that a school that is "operated as an activity or function of" a church may qualify as an "educational organization" for purposes of section 117(d), even though not separately organized or incorporated. It concluded,
An unincorporated school operated by a church or parish … or the school system of a synod or diocese, all may constitute "educational organizations" described in 170(b)(1)(A)(ii) for purposes of section 117(d). The employees generally of such an "educational organization" would be eligible to receive excludable "qualified tuition reductions" from their employer; the exclusion is not limited solely to individuals providing teaching services, but would extend to the employees generally within such function, including secretarial, managerial, administrative, and support function employees.
>However, in these circumstances, an excludable [qualified tuition reduction] could not be extended to church employees who were not employed within the context of the school function, or "educational organization," so defined. Thus, for example, a diocese operating a school system may not properly exclude from reportable wages as "qualified tuition reductions" … the value of tuition reduction benefits it might provide to employees of a hospital it also operates.
Relevance to church treasurers. Does your church operate a private school? If so, do you offer tuition discounts to both church and school employees? If you do, then this article is directly relevant to you. Here are the main points to note:
1. The fact that your school is a ministry of the church, and is not separately incorporated, does not prevent it from being treated as an educational institution under section 117 of the tax code. This means that tuition reductions you offer to school employees may be nontaxable if they are "qualified" as defined above.
2. Qualified tuition reductions are nontaxable regardless of the school employee's position. This benefit is not limited to teachers and administrators.
3. Most importantly, tuition reductions offered to church employees do not benefit from this exclusion and remain fully taxable. To illustrate, if your church offers a 50% tuition reduction to school and church employees, and your annual tuition is $3,000, then you would have to report $1,500 of income to each church employee who is given a tuition discount because of a child attending the school. For school employees, the tuition reduction is a nontaxable benefit.
4. Some church employees may perform duties at a church-operated school. Common examples are a senior pastor of a church who serves as president of a church school, or a youth pastor who teaches one or two courses each year at a church school. It is possible that these church employees may qualify for a nontaxable tuition reduction on account of the services they perform on behalf of the school. The IRS did not address this possible exception in its recent ruling.