A couple of times recently, I’ve talked with taxpayers about their business education deductions. And they have questions.
Some small business owner spends money on an MBA program—and she wonders whether this represents a legitimate deduction.
Or some entrepreneur or real estate professional devotes a bunch of energy to self-study and independent learning—and he wonders.
This blog post talks about the deductibility of these sorts of expenditures.
First a Clarification: Tacit vs. Explicit Knowledge
Before we get into the weeds on this, however, I want to define a couple of terms: explicit knowledge and tacit knowledge. Because without this understanding, you severely limit your tax deductions.
Explicit knowledge is the stuff you learn in a book or a classroom. Explicit knowledge, and here I quote Wikipedia is, “knowledge that can be readily articulated, codified, accessed and verbalized.”
Tacit knowledge is basically knowledge that you don’t get from a book or in a classroom. Wikipedia again provides a pretty good definition saying, “Tacit knowledge (as opposed to formal, codified or explicit knowledge) is the kind of knowledge that is difficult to transfer to another person by means of writing it down or verbalizing it.”
Note: If you really get into this issue of when you can or should deduct education expenses as a small business or as a real estate investor, you probably want to read both Wikipedia articles. (Here are the links Tacit Knowledge and Explicit Knowledge.)
But for now, just hang on to these definitions. We’re now going to dig into the details of the education deduction rules. And you’ll want this information to optimize your tax savings.
Reviewing Business Education Deductions Rules
Tax laws don’t specifically say that amounts spent by a business or by a real estate investor on education or educational activities are deductible. But for businesses, a chunk of law called Sec. 162 says that businesses do get to deduct the ordinary and necessary expenses related to running the business. And for real estate investors, another chunk of tax law, Sec. 212, essentially says the same rule applies when you’re talking about the stuff a taxpayer does that relates to the production of income.
The regulations (which are the IRS’s detailed rules for interpreting and implementing the actual laws passed by Congress like the Sec. 162 and Sec. 212 laws just mentioned) do provide explicit approval of education deductions and give further clarification. These education expense regulations say:
- You can’t deduct the expenses for education that is required to meet the minimum requirements of a new trade or business.
- You can’t deduct expenses for education that qualifies a taxpayer for a new trade or business.
- You can’t deduct as “expenses for education” amounts you spend on travel. (In other words, you can’t recategorize “travel” expenses as “education” expenses even if you learn stuff while you travel.)
- You can’t deduct expenses that connect to tax exempt income or income that’s excluded from gross income.
The regulations also don’t define the words “education” or “educational” but they do provide a bunch of examples of stuff that counts. And to summarize, what they say is that the stuff people use to learn explicit knowledge all work: formal instruction, degree programs, refresher courses, vocational training and so forth.
A bunch of court decisions further flesh out the situation by identifying numerous other examples of learning including basically anything people have historically used to obtain explicit knowledge and then a bunch of stuff a taxpayer might use to obtain tacit knowledge including isolated courses, language lessons, tutoring, and professional continuing education.
And this important point: The courts have explicitly recognized something that makes total sense once someone understands that not all knowledge is explicit: Many informal activities also add to someone’s knowledge, including experience, psychoanalysis, research and even (before the law changed) travel. And these can count as business education deductions, too.
Actionable Approaches to Business Education Deductions
What does the above all mean? Let me share a handful of key takeaways that I see in all this.
First, as long as you know the rules, you should be able to deduct business education. Yes, some stuff isn’t deductible. But many items are.
Second, you should be able to deduct not just the cost of education to obtain explicit knowledge but also the cost of education and educational acitivites that allow you to obtain tacit knowledge.
As a sidebar, I doubt you or I can expect to earn true profitability in our small business activities or direct real estate investments unless we have not just the easily-obtainable explicit knowledge but also a reservoir of tacit knowledge. You might be even be interested in my musings about the modest profitability of small CPA firms, a situation I attribute essentially to inadequate tacit knowledge.
Third, if you are going to make investments in your education you will want to do an excellent job of documenting the connection between business education deductions and your business or real estate investing. Further, I think you probably need to go to more work to document tacit knowledge educational activities in order to safely protect an educational activities deduction in an audit.
Fourth this final point: Even if you can’t deduct the expenses of obtaining tacit information? Hey, seriously, you and I still need to make these investments. In our world of ever-increasing complexity, we need to continually update our explicit knowledge and methodically acquire new tactic knowledge. Even if we don’t get a tax deduction.