Whenever your student receives any money in the form of a scholarship, a fellowship, or an outright grant, you need to determine whether some, or all, of that money is subject to income tax, payable by the student. If the money that the student receives is in the form of a loan, there are no tax consequences upfront, although as the loan is being repaid, some of the interest may be tax-deductible.
Financial aid officers are generally a pretty savvy group of people who have a great knowledge of tax issues surrounding students, but they may not have much idea of your personal circumstances. If your student receives a financial aid award that creates tax problems for you or for your student, don't hesitate to contact the financial aid office and try to reformulate the terms of the award to either minimize or totally eliminate the tax implications. Although it's best to make any changes before any money changes hands, you may still be able to change the terms of the award as long as payments remain to be made.
Figuring Out What's Taxable And What's Not
According to the IRS, the following requirements must be met in order for the scholarship money not to be taxed:
- The student must be a degree candidate at an educational institution that maintains a regular faculty and curriculum and has a regularly enrolled student body in a place where it carries on its activities. In other words, your student may attend a primary, secondary, or postsecondary school, and whether or not she ever receives her degree, she has to be working towards one. Scholarships for continuing education courses that don't lead to a degree won't qualify here; neither will fees that you pay to audit a course.
- The scholarship or fellowship payment may not be considered as payment for services performed. Money received for a research or teaching assistantship generally is taxable, but money received as tuition reduction is not.
- The money has to go toward tuition and/or required fees and expenses. The student has to pay tax on all other funds that are used to pay for room and board and other living expenses. The fact that the organization granting the scholarship may not make this breakdown for you doesn't mean that you don't have to — you do. It's your responsibility to keep track of both your expenses and the resources used to pay for them.
The table, based on IRS Publication 520, shows how the IRS breaks down what's taxable and what isn't:
|Payment for||Degree Candidate||Non-degree Candidate|
Table: Tax Treatment of Scholarship and Fellowship Payments
Amounts received to cover tuition, fees, books, supplies, and equipment are nontaxable only if those expenses are required of all students in that course. For example, suppose that your student chooses to buy a computer that isn't required but that makes his life easier and allows him to achieve better results than he would have without the computer. Even if your student receives an A when he might otherwise have received a B, he still has to declare the funds used to buy the computer on his income tax returns, and pay any tax due.
As you know, all rules have exceptions. Most scholarships and fellowships can be broken down into their taxable and nontaxable components fairly easily by using the table, but here are some special situations:
- Veterans' benefits, including any money that you receive through laws administered by the Department of Veterans Affairs, whether or not that money is used to pay for required tuition and fees or for living expenses, is tax-free.
- All amounts received under the National Health Service Corps Scholarship Program and the Armed Forces Health Professions Scholarship and Financial Assistance Program are tax-free even if you use a portion of that money to pay living expenses.
- Qualified tuition reduction programs for graduate students that are provided in exchange for teaching or research are tax-free if the value of the fellowship is used to offset tuition charges. In other words, the student here is teaching or doing research in exchange for tuition, not in exchange for a living-expense stipend.
Dealing With Self-employment Income From Fellowships
Even if your student needs to report a portion of his scholarship or fellowship to the IRS, chances are good that any income tax liability on that money will be minimal; after all, students are not famous for being high-bracket taxpayers.
Unfortunately, if your student receives a fellowship or stipend in the form of payment in exchange for research or teaching in excess of $400 (as opposed to tuition reduction), and if that student is not treated as an employee of the organization paying the money, she's also subject to self-employment tax, the tax that any individual pays for Social Security and Medicare plus the matching amount that an employer would be required to contribute if you were employed by someone else.
And this tax really hurts — it's a flat 15.3 percent (the 7.65 percent you always pay for Social Security and Medicare taxes plus the matching 7.65 percent your employer would normally pay) of 92.35 percent (your full self-employment income less the 7.65 percent employer match that you now have to pay) of your self-employment income. No itemized deductions or exemptions are allowed (although valid expenses incurred in the process of earning this money can be deducted). The self-employment tax isn't graduated to be kinder to lower-income individuals, and you aren't allowed to apply any credits against it. So a graduate student who receives a $500 stipend in exchange for creating the index for a professor's book may well not pay any income tax on that money, but would have to cough up $70.65 to the IRS in self-employment tax. Your starving student will, no doubt, appreciate the fact that, 45 years down the road, she'll be entitled to receive Social Security and Medicare because she's made this payment now.
Claiming The Hope Credit, Lifetime Learning Credits, And Tuition And Fees Deductions
If your student has to pay some tax on a scholarship, fellowship, or grant, he may also be eligible to take advantage of the Hope Credit, the Lifetime Learning Credit, or the tuition and fees deduction on his income tax return.
The precise rules of who may, or may not, use these credits and deductions, and to offset what expenses, are somewhat complex. The general point of all of them, however, is to give some tax relief to parents and/or students (depending on who is actually paying the education expenses) for the taxable income they're using to pay tuition and required fees at a qualified college. You aren't allowed to use expenses for room, board, books, supplies, and living expenses in order to qualify for the credit, and income limitations exist for all three — if the person trying to claim the relief is making too much money, the credit or deduction will be limited or eliminated altogether.
The basic outlines of these credits and deductions are as follows:
- Hope Credit: This is a $2,500 credit (100 percent of the first $2,000, and 25 percent of the second $2,000) against qualified tuition paid per student in the first two years of postsecondary education leading to a degree. You may claim this credit for only two years for each student, and you may not also claim a Lifetime Learning Credit for the same student in a year in which you claim the Hope Credit.
- Lifetime Learning Credit: This is a credit of up to $2,000 against the cost of qualified tuition payments at a rate of 20 percent (you need $10,000 worth of tuition expenses to claim the full credit). You may claim this for as many years as you have qualified expenses, but the credit is per tax return, not per student.
- Tuition and fees deduction: Up to $4,000 of qualified tuition and fees paid to a qualified postsecondary educational institution may be deducted from gross income if you used taxable funds to pay for those expenses and if you don't use those same taxable funds to claim either the Hope Credit or the Lifetime Learning Credit. You may claim this deduction for as many years as you like, the courses for which you're paying tuition don't have to lead to a degree, and tuition for all members of your family for whom you claim a dependency exemption qualify.
Just as you do with almost every other tax provision, be careful not to double dip and use the same expenses to try to qualify for both a Hope or Lifetime Learning Credit and the tuition and fees deduction. On the other hand, many people pay tuition expenses far in excess of what is covered by any one of these credits or deductions. If you have enough qualified tuition expenses for enough people in your family, you could be eligible for both credits and the tuition and fees deduction in a single year.