Rev. Rul. 83-3
(1) May a veteran deduct educational expenses if the amounts expended are allocable to veterans benefits that are exempt from taxation?
(2) May a minister deduct interest and taxes paid on a personal residence if the amounts expended are allocable to a rental allowance excluded from gross income under section 107 of the Internal Revenue Code?
(3) May a student deduct educational expenses if the amounts expended are allocable to a scholarship that is excluded from gross income under section 117 of the Code?
Situation 1. During a taxable year, an unmarried veteran with no dependents, who is an attorney employed by a law firm, received five monthly payments totalling $780 from the Veterans' Administration pursuant to 38 U.S.C. section 1651 et seq., which provides for educational assistance allowances. The purpose of the allowance is to meet, in part, the expenses of a veteran's subsistence, tuition, fees, supplies, books, equipment, and other educational costs. 38 U.S.C. section 1681(a) (1979). Based upon the legislative history behind 38 U.S.C. section 1681 (1979), it is determined that Congress intended one-half of the allowance to be attributable to subsistence and one-half to be attributable to educational costs. See S. Rep. No. 269, 89th Cong., 1st. Sess. 17 (1965). These payments are exempt from taxation under 38 U.S.C. section 3101(a) (1979). The taxpayer incurred expenses for tuition, fees, books, and other expenses in connection with three courses of advanced law education taken at a local university. The employer required the attorney to take the three courses as a condition of continued employment.
During the year, the veteran incurred and paid expenses of $1,054 for the education.
Educational expenses for courses required by the employer as a condition of continued employment generally are deductible as ordinary and necessary business expenses under the provisions of section 162 of the Code, provided the taxpayer elects to itemize deductions.
Situation 2. During the taxable-year, a minister of a gospel who is employed as a pastor of a church received $19,000 as compensation from the church and a combined rental and utility allowance of $6,300. The rental and utility allowance is excludable from the gross income of the minister under section 107 of the Code, to the extent used to rent or provide a home.
During the year, the minister used the rental and utility allowance, together with other funds, to make monthly payments for the residence in which the minister lived. Those payments totaled $8,400 and consisted of principal ($500), insurance ($400), real estate taxes ($1,400), interest ($4,000), and utility costs ($2,100). The minister incurred no other expenses directly related to providing a home during the taxable year. Interest and real property taxes paid are generally deductible expenses under the provisions of section 163 and 164 of the Code, respectively, provided the taxpayer elects to itemize deductions.
Situation 3. Same as in Situation 1, except the taxpayer is not a veteran and the $780 qualified as an amount received as a scholarship solely attributable to tuition that is excludable from gross income under section 117 of the Code.
LAW AND ANALYSIS
Section 162 of the Code allows as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.
Section 163 of the Code allows as a deduction all interest paid or accrued within the taxable year on indebtedness.
Section 164 of the Code allows, except as otherwise provided, as a deduction for the taxable year within which paid or accrued, state and local real property taxes.
Section 265(1) of the Code provides that no deduction shall be allowed for any amount otherwise allowable as a deduction that is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by subtitle A of the Internal Revenue Code, or any amount otherwise allowable under section 212 that is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by subtitle A.
Section 1.265-1(c) of the Income Tax Regulations provides that expenses and amounts otherwise allowable that are directly allocable to any class or classes of exempt income shall be allocated thereto, and expenses and amounts directly allocable to any class or classes of nonexempt income shall be allocated thereto. If an expense or amount otherwise allowable is indirectly allocable to both a class of non-exempt income and a class of exempt income, a reasonable proportion thereof determined in the light of all the facts and circumstances in each case shall be allocated to each.
The purpose of section 265 of the Code is to prevent a double tax benefit. In United States v. Skelly Oil Co., 394 U.S. 678 (1969), 1969-1 C.B. 204, the Supreme Court of the United States said that the Internal Revenue Code should not be interpreted to allow the practical equivalence of double deductions absent clear declaration of intent by Congress. Section 265(1) applies to otherwise deductible expenses incurred for the purpose of earning or otherwise producing tax-exempt income. It also applies where tax exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose. In such event, it is proper to conclude that some or all of the deductions are allocable to the tax exempt income. See Heffelfinger v. Commissioner, 5 T.C. 985 (1945), which held that Canadian income taxes on income exempt from U.S. tax are not deductible in computing U.S. taxable income; Banks v. Commissioner, 17 T.C. 1386 (1952), which held that certain educational expenses paid by the Veterans' Administration that were exempt from income tax, were not deductible; Christian v. United States, 201 F. Supp. 155 (E.D. La. 1962), where a school teacher was denied deductions for expenses incurred for a literary research trip to England because the expenses were allocable to a tax-exempt gift and fellowship grant; and Rev. Rul. 74-140, 1974-1 C.B. 50, which concludes that the portion of the state income tax paid by a taxpayer that is allocable to the cost-of-living allowance, a class of income wholly exempt under section 912 of the Code, is nondeductible under section 265.
In Manocchio v. Commissioner, 78 T.C. 989 (1982), a taxpayer attended a flight-training course that maintained and improved skills required in the taxpayer's trade or business. As a veteran, the taxpayer was entitled to an educational assistance allowance from the Veterans' Administration pursuant to 38 U.S.C. section 1677 (1976) equal to 90 percent of the costs incurred. Because the payments received were exempt from taxation under 38 U.S.C. section 310(a) (1976), the taxpayer did not report them as income. The taxpayer did, however, deduct the entire cost of the flight training course, including the portion that had been reimbursed by the Veterans' Administration. In a reviewed opinion, the court held that the reimbursed flight-training expenses were nondeductible under section 265(1) of the Code.
In Manocchio, the petitioner contended that the Service was estopped from challenging the claimed deduction because of petitioner's reliance on the holding of Rev. Rul. 62-213, 1962-2 C.B. 59, that held that expenses for education, paid or incurred by veterans, that are properly deductible for federal income tax purposes, are not required to be reduced by the nontaxable payments received during the taxable year from the Veterans' Administration.
In rejecting petitioner's argument, the court stated that the Internal Revenue Service has very broad discretion to correct a mistake of law in a ruling and do so with retroactive effect. The court stated:
"Given the fundamental differences in the way these benefits are computed, we cannot say that respondent's decision to treat them differently for tax purposes is 'so devoid of rational basis' as to constitute an abuse of discretion." 78 T.C. 989, 1002, 1003.
In all three situations, the taxpayer has incurred expenses for the purposes for which the tax-exempt income was received. Permitting a full deduction in each situation would lead to a double benefit not allowed under section 265 of the Code.
In Situation 1 and Situation 3, the amount of the itemized deductions for tuition, books and other expenses connected with further education must be decreased to the extent the expense is allocable to the amounts received for such expenses from the Veterans' Administration or as a scholarship, as the case may be.
In Situation 2, the amount of the itemized deductions otherwise allowable for the interest and real estate taxes must be decreased to the extent the expenses are allocable to the rental allowance received from the church.
The following demonstrates one reasonable method of allocation under section 1.265-1(c) of the regulations that will be accepted by the Internal Revenue Service.
In Situation 1, the $1,054 of educational expenses that otherwise qualify for deduction is decreased by one-half of $780 (or $390), computed by multiplying $1,054 (the amount of the expense that is otherwise deductible) by a fraction, the numerator of which is $390 (the amount of the reimbursement allocable to deductible educational costs) and the denominator of which is $1,054 (the total of all expenditures to which the reimbursement is applicable): $1,054 x 390 / $1,054 = $390. Therefore, the itemized deduction for educational expenses under section 162 is $664 ($1,054 - $390).
In Situation 2, the $4,000 of interest otherwise deductible under section 163 of the Code is decreased by $3,000, computed by multiplying $4,000 (the amount of the interest otherwise deductible) by a fraction, the numerator of which is $6,300 (the combined rental and utility allowance) and the denominator of which is $8,400 (the total of all expenditures to which the rental and utility allowance is applicable), or $4,000 x $6,300 / $8,400 = $3,000. Therefore, the deduction for interest allowable under section 163 in Situation 2 is $1,000 ($4,000 - $3,000).
In Situation 2, the $1,400 of real estate taxes otherwise deductible under section 164 of the Code is decreased by $1,050 computed by multiplying $1,400 (the amount of the real estate taxes otherwise deductible) by a fraction, the numerator of which is $6,300 and the denominator of which is $8,400 (as indicated in the preceding paragraph), or $1,400 x $6,300 / $8,400 = $1,050. Therefore, the itemized deduction for real estate taxes allowable under section 164 in Situation 2 is $350 ($1,400 - $1,050).
In Situation 3, the $1,054 of educational expenses that otherwise qualify for deduction is decreased by $780, computed by multiplying $1,054 (the amount of the expense otherwise deductible) by a fraction, the numerator of which $780 (the amount of the scholarship) and the denominator of which is $1,054 (the total of all expenditures to which the reimbursement is applicable): 1,054 x 780 / 1054 = 780. Therefore, the itemized deduction for educational expenses allowable under section 162 is $274 ($1,054 - $780).
EFFECT ON OTHER REVENUE RULINGS
Situation 1 and 2 of this revenue ruling are similar to the situations in Rev. Rul. 62-213, 1962-2 C.B. 59, and Rev. Rul. 62-212, 1962-2 C.B. 41, which hold that the amounts paid by the taxpayers are fully deductible.
Under the authority contained in section 7805(b) of the Code, this revenue ruling will not be applied to educational expenses paid by veterans who are currently enrolled in an educational program and incurring expenses under the circumstances described in Situation 1 until the end of the current academic year, but no later than June 30, 1983. Further, if the minister described in Situation 2 owned and occupied a home before January 3, 1983, (or had a contract to purchase a home before January 3, 1983, and subsequently owns and occupies that home), the revenue ruling will not be applied to that minister until the earlier of the date on which the minister no longer occupies that home or January 1, 1985.
Section 7805(b) will not be applied in Situation 3 because that situation is like Manocchio, cited above, and the rationale of that case is equally applicable to the facts of Situation 3.