Tax treatment of scholarships
May 13, 2010 Leave a comment
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. 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 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 taxable scholarship amounts should 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. However, it is treated as “earned income.” This means if the student is being claimed as a dependent by his parent, and using the standard deduction he or she may qualify for a higher standard deduction.
The standard deduction allowed to dependents is the greater of: (a) $950 for 2009 ($900 for 2008) or (b) $300 (for 2008 and 2009) plus the dependent’s earned income. But the standard deduction can’t be more than the regular standard deduction ($5,700 for single taxpayers in 2009; $5,450 in 2008). So even though part of a scholarship is taxable, it may be “covered” by the standard deduction.
Example. Tim is a dependent of his parents. His only income is $3,000 he received as part of a scholarship, which is taxable because it was applied to cover his costs of room and board. Since the $3,000 is treated as earned income, Tim is entitled to a $3,300 standard deduction, which reduces his taxable income to zero.
(3) The tax-free scholarship may limit other higher education tax benefits you or your child may be entitled to. 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 (i.e., the Hope credit, as modified for 2009 and 2010) and Lifetime Learning credit.
Deduction for higher education expenses.
Deduction for interest on student loans
Coverdell ESA distribution exclusion.
Qualified tuition (529) plan distribution exclusion.
Savings bond interest exclusion.
In other words, neither you nor your child may claim a credit, deduction, or exclusion based on expenses paid with tax-free scholarship funds. (However, a student can voluntarily allocate a portion of the scholarship money to room & board by filing a tax return and reporting it as income. His parents then can claim a credit or deduction since the amount they paid would now be allocated to tuition and fees.)
Note that we help parents with a college-bound high school student, who won’t qualify for need-based financial aid, reduce their college expenses by thousands of dollars. In many cases our customized planning results in a family knocking off a full year’s cost of college. Please contact us for more information.