<p>Tax aspects of Scholarships and fellowships, Part I: </p>
<p>There seems to be constant questions reqarding these areas.Accordingly, enclosed is a letter written about 6 months ago about this. I have also added some additional information after the letter for some further elaboration. Hopefully, this will end these questions:</p>
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<p>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 is used for nonqualifying items, it is taxable. The recipient is responsible for determining 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) You should still get dependency exemption. Your dependency exemption for your child shouldn't be threatened by the scholarship. To claim an individual as your dependent, you must provide more than 50% of his support. Since education is a support item, to the extent that education costs are paid by an outside source, the amount of support you are providing could fall below 50%. However, 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.
Example. Ellen's parents provide $8,000 towards her support and she receives a $10,000 college scholarship. If the scholarship were included in Ellen's total support, the parents' $8,000 wouldn't be more than 50% of her support ($18,000) and they wouldn't qualify to claim her as their dependent. However, since the scholarship isn't included in her support, the parents qualify.
(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.
If an individual is a dependent, his or her standard deduction is limited (in 2004) to the greater of (a) $800, or (b) the sum of $250 plus the individual's earned income. But the standard deduction can't be more than the regular standard deduction ($4,850 for single taxpayers for 2004). 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 $3,250 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:
Hope and Lifetime Learning credits.
Deduction for higher education expense.
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.</p>
<p>However, educational assistance provided by a government unit or an Indian tribe may be tax-exempt under the "general welfare exclusion" ( ¶ J-1480A). Thus, educational assistance payments provided by a corporation organized under Indian tribal law to tribe members with family income below the national median were excludable as general welfare payments. But payments to tribe members with family income equal to or greater than the national median were taxable unless they were "qualified scholarships"</p>
<p>Elaboration:
I. Gross income doesn't include any amount received as a qualified scholarship ( ¶ J-1232) by an individual who is a candidate for a degree ( ¶ J-1245) at an educational organization ( ¶ J-1244). 1.1 Thus, nondegree candidates cannot exclude scholarship income from gross income. 2</p>
<p>1.1 Code Sec. 117(a) ; Prop Reg § 1.117-6(b)(1).
2 H Rept No. 99-426, PL 99-514, p. 102.</p>
<p>II, In addition,The recipient of the scholarship or fellowship grant is responsible for determining whether the grant is, in whole or in part, includible in gross income. 3.1. Thus, you can't trust whether the sponsoring scholarship categorization of taxability.</p>
<p>3.1 Letter ruling 200226005</p>
<p>Moreover,The grant need not be limited by its express terms to tuition and course-related expenses. An otherwise qualified scholarship is excludible (taking into account any other excludible grant to the individual) up to the aggregate amount of tuition and related expenses incurred by the individual for the period of the grant. But a grant which by its terms cannot be used for tuition and related expenses or which is earmarked for other purposes (such as room and board) isn't excludible. 5 </p>
<p>5 Conf Rept No. 99-841, Vol. II, PL 99-841, pp. II-16; Prop Reg § 1.117-6(c)(1).
illustration: Taxpayer, a degree candidate, receives a $2,000 scholarship, with $1,000 specifically designated for tuition and $1,000 specifically designated for living expenses. Taxpayer's tuition is $1,600. Taxpayer may exclude $1,000 from income, but the other $1,000 designated for living expenses must be included in income.</p>
<p>3.1 IRS Letter Ruling 200226005.</p>
<p>III. In addition:scholarship prize won in a contest is not a scholarship where there is no requirement that it be used for educational purposes. But if the winner can only use the prize money to pay tuition, the prize is a scholarship governed by Code Sec. 117. </p>
<p>IV. What is covered:</p>
<p>An otherwise qualified scholarship is excludible up to the amount used for qualified tuition and related expenses, see ¶ J-1232. Qualified tuition and related expenses means:
(1) tuition and fees required for the enrollment or attendance of a student at an educational organization described in Code Sec. 170(b)(1)(A)(ii) 6 (see ¶ J-1244).
(2) fees, books, supplies and equipment required for the courses of instruction at the educational organization. 7</p>
<p>6 Code Sec. 117(b)(2)(A) ; Prop Reg § 1.117-6(c)(2)(i).
7 Code Sec. 117(b)(2)(B) ; Prop Reg § 1.117-6(c)(2)(ii).
Under proposed regs, to qualify for exclusion, the fees, books, supplies, and equipment would have to be required of all students in the particular course. 8 </p>
<p>8 Prop Reg § 1.117-6(c)(2).
Illustration: S is a scholarship student at a university where he is enrolled in a writing course. "Suggested" supplies for the writing course include a word processor, but students in that course aren't required to buy word processors. Under the proposed regs, S wouldn't be able to include the cost of a word processor in calculating his exclusion. 8.1</p>
<p>8.1 Prop Reg § 1.117-6(c)(6), Ex (1), Ex (1). </p>
<p>Part II of this post will be right under this</p>