Scholarship Exclusion

Save your taxpayer client about $ 1,000 by Electing Out of the Exclusion of Scholarships from Taxable Income.

Though at first it may appear counter-intuitive, sometimes it is advantageous for a student to treat some of their non-taxable scholarship income as taxable.

Qualifying expenses for purposes of the American Opportunity Credit (AOC), Lifetime Learning Credit (LLC), and the Tuition and Fees Adjustment (T&FA) are limited to tuition and fees; plus books, supplies, and equipment for AOC only. When a scholarship is excluded from taxable income (under IRC Section 117), it reduces the amount of qualified expenses available for purposes of an education credit or adjustment. However, if the terms of a scholarship allow for payment of other expenses, such as room and board or research, it may be advantageous to report excludable scholarship amounts as taxable income. The amount reported as income would then not reduce qualifying expenses for purposes of the education credits or adjustment.

Note: This choice is only available in the case of unrestricted scholarships that may be used to pay expenses other than qualifying expenses. For a restricted scholarship, where the terms require payment of qualifying tuition and fees, qualified expenses must be reduced by the tax-free amount of the scholarship.

Example:

Josh is not claimed as a dependent on his parents’ tax return.

He receives a $7,000 scholarship for his first year of college.

His total tuition for 2010 is $5,000. He uses $5,000 of the scholarship for qualified tuition expenses and the remaining $2,000 is used for nonqualified expenses (such as room and board).

Josh also earned $9,000 in wages during the year.

His tax liability for 2010 is $166:

  • Case 1: No Elect out of ExclusionWage income $9,000Taxable scholarship $2,000

    AGI $11,000

    Exemption/standard deduction < $9,350 >

    Taxable income $1,650

    Tax before credits $166

    American Opportunity Credit $0

    Tax after credits $166

    Refundable AOC $0

However, if he elects to use $4,000 of the scholarship for tuition and $3,000 for nonqualified expenses, his tax liability for 2010 is zero and he receives a $400 refundable AOC:

  • Case 2: Partial Elect out of ExclusionWage income $9,000Taxable scholarship $3,000

    AGI $12,000

    Exemption/standard deduction < $9,350 >

    Taxable income $2,650

    Tax before credits $266

    American Opportunity Credit <$266 >

    Tax after credits $0

    Refundable AOC $400

His best case is to elect to use $1,000 of the scholarship for tuition and $6,000 for nonqualified expenses. His tax liability for 2010 is zero and he receives a $1,000 refundable AOC:

  • Case 3: Maximizing AOC by Electing out of Exclusion

    Wage income $9,000

    Taxable scholarship $6,000

    AGI $15,000

    Exemption/standard deduction $9,350

    Taxable income $5,650

    Tax before credits $568

    American Opportunity Credit $568

    Tax after credits $0

    Refundable AOC $1,000

Art Rudeseal, TCS CO1; Instructor, District 18 Boulder