By Mark C. Nielsen and James M. Hopkins at The Tax Adviser on July 1, 2019
- Sec. 117 excludes from gross income scholarship proceeds used to pay qualified tuition and related expenses at qualified educational institutions received by students who are candidates for degrees at those institutions.
- Scholarship proceeds used for expenses other than qualified tuition and related expenses (i.e., tuition, fees, books, and equipment required for the enrollment or attendance of a student at an educational institution or for a specific course taken at the institution) are generally included in income and considered to be unearned income.
- The law known as the Tax Cuts and Jobs Act amended the rules for the tax on children's unearned income, commonly called the kiddie tax, so that it no longer is calculated at the parents' top marginal rate and is instead calculated at modified trust and estate tax rates.
- Students subject to the kiddie tax may need to file Form 8615, Tax for Certain Children Who Have Unearned Income. In some situations, students will need to use information not provided on Form 1098-T, Tuition Statement, to properly fill out Form 8615.
- The change in the kiddie tax rates could cause some students to incur a larger tax liability due to the treatment of scholarship proceeds as unearned income than under the old kiddie tax rules. However, by following certain strategies, students may be able to reduce the amount of their unearned income from scholarships and avoid a kiddie tax liability.
Every fall, students all over the country set off to attend various colleges and universities. With the rising cost of higher education, many of these students are looking forward to receiving some form of scholarships to pay a portion or, in some cases, all of their tuition. This article reviews how some of these scholarships might be considered taxable income to the student. With the law known as the Tax Cuts and Jobs Act (TCJA) signed into law in 2017, this income, which is subject to the "kiddie tax" rules, is taxed at estate and trust tax rates, which can quickly climb to as much as 37%.1
In many cases, scholarships are not taxable. In fact, most students do not need to fear paying any tax on scholarships and fellowship grants because they are excluded from gross income under Sec. 117 as long as they are used for qualified tuition and related expenses,2 have not been earmarked for other purposes,3 and go to a student who is a candidate for a degree4 at a qualified educational organization.5 Qualified tuition and related expenses in this case include required tuition, fees, books, supplies, and equipment.6
An expense that most people commonly assume to be included in the qualified tuition and related expenses list is room and board, but it is not. Any scholarship or fellowship grant that is used to pay for room and board, or something else that is not considered qualified tuition or a related expense, is taxable. In addition, a scholarship may also be taxable when the scholarship is earmarked for a nonqualifying purpose such as room and board or travel.7 In these situations, the amount of the earmark is taxable.
Not all payments made to a student or the school he or she is attending for qualified tuition or related expenses meet the requirements to be classified as a scholarship for purposes of the Sec. 117 exclusion. In general, a payment for services is not excluded from gross income. There are exceptions to this rule for the National Health Service Corps Scholarship Program, the Armed Forces Health Professions Scholarship and Financial Assistance Program, and a comprehensive student work-learning-service program.8 Also, qualified tuition reductions for graduate students are tax-free if the graduate student performs teaching or research activities for an eligible educational institution.9 Unless one of these exceptions applies, the student should receive a Form W-2, Wage and Tax Statement, for the income earned for the service performed. Any income reported on a Form W-2 will be considered earned income.
In addition, although they are not Sec. 117 scholarships, any qualifying payment received through the Department of Veterans Affairs that is used to pay for education or training, such as funds received under the GI Bill, are not included in income.10