Taxation of Scholarships

In general, scholarships and fellowships for tuition and related costs are tax free, but there are some rules and exceptions.

First, the individual receiving the scholarship must be a degree candidate at an 'educational institution.' That is, the school must maintain a regular faculty and curriculum with an enrolled body of pupils in attendance. Thus, for example, correspondence schools would not qualify. Technical or vocational schools can qualify with proper accreditation.

Second, the payments cannot be linked to services to be provided by the student. Thus, for example, to the extent the payment is for the individual's work as a teaching assistant or researcher it's taxable income.

Third, only payments for tuition and 'related expenses' qualify as tax free. Related expenses include fees, books, supplies, and equipment required of all students in the particular course. Thus, for example, if a word processor were recommended but not required, buying one would not be a 'related expense.' Other expenses, which do not qualify, include the cost of room and board, travel, research, and clerical help. To the extent the scholarship is used for nonqualifying items, it is taxable.

The above rules apply whether the scholarship is in the form of a direct payment to the individual or is a tuition reduction award.

Related issues. Your child's scholarship can have an impact on a number of related tax issues, as follows:

1. Dependency exemption. To claim an individual as your dependent you must provide more than 50% of his support. Since the cost of education is a support item, to the extent it is being provided by an outside source (the scholarship), the amount of support you are providing could fall below 50%. However, a special rule provides that educational costs covered by a scholarship for a dependent who is a child of the taxpayer (but not for other dependents) are not included in the calculation of total support. Thus, your dependency exemption should not be threatened by the scholarship

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 would not constitute more than 50% of her support ($18,000) and they would not qualify to claim her as their dependent. However, since the scholarship is not included in her support, the parents qualify.

2. Taxable scholarship as 'earned income.' As noted above, to the extent awarded funds are spent on room, board, or other nonqualifying expenses, the scholarship 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 may qualify for a higher standard deduction. If an individual is a dependent, his standard deduction is limited to $650, or, if higher, earned income (although it can never exceed the regular standard deduction ($4,000 for single taxpayers in 1996)). 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 $3,000 standard deduction, which reduces his taxable income to zero.

I hope this helps you understand the tax impact of scholarships. If you would like additional information, please contact us.

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