Taxation around Scholarships

The data on typical yearly educational funding shows that parental contributions cover around 40% of college costs; a close second is scholarships and grants pegged at 25%. Close to 2 million scholarships are awarded each year; the U.S. Department of Education alone awards 46 billion dollars in scholarships and private sources award close to 8 billion dollars in scholarships annually. Almost none go unclaimed. Such is the impact of scholarships!

Scholarships help reduce the ticket price of a degree thereby offsetting the cost of education for millions of school-goers who apply for scholarships each year through federal, academic, or private organizations. The cherry on the cake is that they don’t have to be repaid. However, not all scholarships are equal, and certainly, not all are tax-free either.

Even though Internal Revenue Service (IRS) policies are favoring towards student’s tax obligations, there are cases when a student could have tax liabilities on scholarship dollars. The last article highlighted the importance of Scholarship as a valuable Education benefit and how outsourcing administration can have various benefits for organizations including tax exemptions. Here we will discuss tax implications around scholarships for both the students and the sponsoring organization and provide some tools that will better serve both.

Before we get into the details of taxation around scholarships, let’s define three key terms that you will encounter multiple times while reading this post or any other literature on this topic.

The first one is an Educational institution. An educational institute according to the IRS has these distinct features:

• It has a continuously enrolled body of students where they carry out educational activities
• It maintains a regular body of faculty members and has a curriculum.
• Is recognized by the Department of Education or is IRS approved.

The second one is Qualified educational expenses. These are all necessary expenses for completing a degree and include tuition, fees, books, supplies, and equipment without which a student is unable to complete the course of study.

And the final one is Surplus expenses. These are incidental expenditures such as room, board, travel expenses, and optional equipment. They may be necessary but are not considered critical to degree completion.

Scholarships are Tax-free if they pay for Qualified Educational Expenses.

Next, let’s discuss the instances where scholarships and grants are tax-free.

According to IRS, Scholarships are tax-free if the recipient is enrolled in a degree in an educational institution and the scholarship dollars are used to pay for tuition, fees, books, supplies, and equipment for courses – also termed as qualified educational expenses.

Scholarships that pay for qualified educational expenses are always tax-free as they are not considered as a part of income for the child or the parent.

Pell grants are always tax-free because they are granted to students who wouldn’t be able to enroll in a college degree otherwise. However, if a part of the grant is used for incidental expenses then that part would be considered taxable.

On the contrary, Emergency aid granted to students during COVID is not considered a part of the gross income and is not taxable even when a part of it is used for incidental expenses.

Taxable Scholarship Income and How to file

The scholarship dollars used to pay for anything over and above the qualified educational expenses are considered surplus and are taxable.

Scholarships may be used to pay for incidental expenditures such as room, board, travel expenses, and optional equipment. The portion of the scholarships used to pay for incidental expenditures will be considered a part of the gross income of the recipient and is subject to taxation.

It is worth noting that even if the parents claim the recipient as a dependent on their tax returns if the scholarship recipient’s gross income exceeds $12,400 the students are required to file tax returns.

Stipends or grants received at the educational institution for services such as research or teaching assistantships are taxable. The student would receive a W2 from the educational institute for the stipends or a part of the school scholarship that is paid for the service.

All colleges release form 1098-T end of January, which talks about the total of scholarships and financial aid applied to your account. You can provide this document to your tax filer and use it while filing tax returns. The part of the scholarship used for non-qualified expenses will have to be reported as SCH under the wages section of the W2.

How to reduce your tax bill

If a part of your scholarship was used to pay for room and board, travel, or non-critical equipment such as laptops it is considered a part of non-qualified expenses and is taxable. However, you could reduce your tax bill with the help of the following educational tax credits.

• American Opportunity Tax Credit (AOTC): This applies to employees pursuing higher Ed. According to IRS, you can receive a maximum of $2500 annually as a tax credit for the first four years of college for money spent on qualified educational expenses at an educational institute. The credit is phased out and has some income restrictions. The credits are refundable, and if your tax bill is reduced to zero then you can get up to 40% back as a tax refund.
• Lifetime Learning Credit (LLC): This can be applied for qualified educational expenses at an educational institute for you or your dependents. There is no limit to the number of years you can claim this credit. However, you can claim a maximum of $2000 per tax return.

Additional resources that will help you file returns if a part of your scholarship is taxable

• Form 1040 for U.S. Individual Income Tax Returns
• Form 1040 for NR Alien Income Tax Returns
• Tax benefits for Education

Summarizing with an example

Let’s say in 2020-21, you received two private scholarships each worth $5000, along with financial aid of $3000, and $2000 emergency aid granted under the CARES act. Most of the dollars paid for tuition, books, and fees ($10,000), and some of it went for room and board, healthcare, and transportation ($5000). You would have still paid zero taxes on the total amount of $15000. Next year, you received lesser in scholarship dollars and financial aid (let’s say the total received was $13,000 without the emergency aid); you used most of it for tuition and fees ($10,000), and a part of it was used for room and board ($3000). The amount of $3000 will be considered taxable income since it pays for what are called non-qualified education expenses. You would have to declare them as SCH under the wages section of your W2. However, you could claim tax credits for them under AOTC or LLC and reduce your tax bill.

Sponsoring organization’s tax liability on scholarship dollars

Next, let’s discuss if there are any tax liabilities for the organizations that provide scholarships to either their employees or dependents or the general public.

Corporate-provided scholarship dollars awarded to individuals or their dependents are tax-free if they fulfill the following criteria laid out by the IRS for Grants to individuals:

• They are awarded in an objective non-discriminatory fashion
• The awards are used for study (degree-seeking or non-degree seeking) at an educational institution
• The award is excluded from the gross income under IRS revenue code 74(b)

Elaborating on the last point under this context, an award can be excluded under IRS revenue code 74(b) if it’s given for educational, scientific, or literary achievement and the recipient may not be required to perform any future services in lieu of the scholarship dollars.

Scholarships can be taxable based on how much the recipient receives and how they spend the scholarship dollars. Since it’s difficult for organizations to track how the awardee spent the benefit dollars, we recommend the scholarship checks be made out in the name of the school the awardee is going to attend. The industry best practice is to leave disclosure of scholarship dollars for tax purposes up to the recipient, and not include this information on the W2.

While hoping the information presented above helped you, I would also like to end the post with a disclaimer. Even though the post is rooted in contemporary research on the topic, the fact remains that Edcor is not a tax expert and even though we provide the best industry knowledge, we recommend you also consult your tax advisor.