Wednesday, October 16, 2019

Tax treatment of scholarships

Receiving a scholarship is exciting and can be beneficial in paying for education costs, but the tax effects of such scholarships can be confusing.

Scholarships (and fellowships) are generally tax-free, whether for elementary or high school students, for college or graduate students, or for students at accredited vocational schools. It makes no difference whether the scholarship takes the form of a direct payment to the individual or a tuition reduction.

However, for the scholarship to be tax-free, certain conditions must be satisfied. The most important are that the award must be used for tuition and related expenses (and not for room and board) and that it must not be compensation for services.

Tuition and related expenses. A scholarship is tax-free only to the extent it is used to pay for (1) tuition and fees required to attend the school or (2) fees, books, supplies, and equipment required of all students in a particular course. For example, if a computer is recommended but not required, buying one wouldn't qualify. Other expenses that don't qualify include the cost of room and board, travel, research, and clerical help.

To the extent a scholarship award isn't used for qualifying items, it is taxable. The recipient is responsible for establishing how much of the award was used for qualified tuition and related expenses so as to be tax-free. You should maintain records (e.g., copies of bills, receipts, cancelled checks) that reflect the use of the scholarship money.

Scholarship award can't be payment for services. Subject to limited exceptions, a scholarship isn't tax-free if the payments are linked to services that your child performs as a condition for receiving the award, even if those services are required of all degree candidates. Thus, a stipend your child receives for required teaching, research, or other services is taxable, even if the child uses the money for tuition or related expenses.

Returns and records. If the scholarship is tax-free and your child has no other income, the award doesn't have to be reported on a return. However, any portion of the award that is taxable as payment for services is treated as wages, and the payor should withhold accordingly. Estimated tax payments may have to be made if the payor doesn't withhold enough tax. Your child should receive a Form W-2 showing the amount of these "wages" and the amount of tax withheld, but any portion of the award that is taxable must be reported, even if no Form W-2 is received.

Your child's award can have the following impact on these related tax issues:

(1) The dependency exemption (suspended for 2018-2025) that you claim for your child shouldn't be threatened by the scholarship. To claim an individual as your dependent, you must meet a support test. Although education is a support item, a special rule provides that educational costs covered by a scholarship (or fellowship) for a dependent who is a child of the taxpayer (but not for other dependents) aren't included in the calculation of total support.

(2) Any scholarship amounts that are taxable to the student will also increase your child's standard deduction. As noted above, to the extent scholarship funds are spent on room, board, or other nonqualifying expenses, the award is taxable. But the portion that's taxable to the student can be absorbed by a higher standard deduction. Because that taxable portion is treated as "earned income" (for purposes of the calculation of the standard deduction amount for dependents, see below), the student will qualify for a higher standard deduction.

The standard deduction allowed to dependents for 2019 is the greater of: (a) $1,100 or (b) $350 plus the dependent's earned income. But the standard deduction can't be more than the regular standard deduction ($12,200 for 2019 for single taxpayers). Thus, even though part of a scholarship is taxable, it may be "covered" by the standard deduction.

Example. T is a dependent of his parents. T's only income is $3,000 T received as part of a scholarship, which is taxable because it was applied to cover T's costs of room and board. Since the $3,000 is treated as earned income, T is entitled to a $3,350 standard deduction, which reduces his taxable income to zero.

(3) The tax-free scholarship may limit other higher education tax benefits to which you or your child may be entitled. Neither you nor your child may claim a credit, deduction, or exclusion for expenses paid with tax-free scholarship funds.

Thus, if your child receives a tax-free scholarship and his or her higher education expenses also qualify for any of the following credits, deductions, and exclusions, the expenses taken into account in computing any of these other benefits must first be reduced by the tax-free amounts used to pay the expenses:

        American Opportunity tax credit and Lifetime Learning credit.

        Deduction for interest on student loans.

        Coverdell ESA distribution exclusion.

        Qualified tuition (529) plan distribution exclusion.

        Savings bond interest exclusion.


Please contact us if you wish to discuss these or related matters further.