Counterintuitive tax planning: Increasing taxable scholarship income to reduce taxes.

• Author: Madison, Thomas

Families faced with financing the costs of higher education must negotiate a complex maze of rules and regulations to minimize their tax liability when using scholarships and educational credits. This complexity is only exacerbated when parents and their dependent children are preparing and filing their taxes at different times and in different locations. Additionally, the fact that obtaining the optimal tax outcome may necessitate actions that are counterintuitive to the typical taxpayer (i.e., electing to increase taxable income to save on total taxes) only serves to reinforce the need for additional professional advice and education on this important tax topic, which this article addresses.

Background

In an effort to promote college affordability, the American Recovery and Reinvestment Act of 2009 (1) mandated that the Departments of Treasury and Education undertake a study to coordinate the American opportunity tax credit (AOTC) and the federal Pell Grant Program. As a result, Treasury delivered the "Report to Congress on Coordinating the American Opportunity Tax Credit and the Federal Pell Grant" in May 2014. (2) The fact sheet (3) that accompanied the report noted that nearly 9 million U.S. taxpayers qualified for educational tax credits; however, it also noted that many taxpayers would forgo the credits because of the AOTC's complexity and because they did not understand the tax treatment of Pell Grants. In addition, Form 1098-T, Tuition Statement, through which schools report tuition and fees, and scholarships and grants, may further confuse taxpayers.

An overview of the American opportunity tax credit

The AOTC can produce a tax benefit for an individual taxpayer by creating a combination of nonrefundable and refundable tax credits totaling as much as $2,500. Under Sec. 25A, these credits are available to a taxpayer who is an eligible student or who claims a dependent who is an eligible student. Eligible students include persons who are seeking a postsecondary degree, certificate, or other recognized postsecondary educational credential and are enrolled at least part time at a qualified educational institution. They must also have not completed their first four years of postsecondary education, not claimed the credit for more than four tax years, and not have a felony drug conviction at the end of the tax year.

The credits are calculated based on required tuition, fees, and course materials (together called qualified educational expenses, or QEE) paid for by cash, check, credit card, or debit card or through loans. When the expenses are for a dependent child, the credit can be claimed on the parents' return if the parents, the child, or a third party is paying the QEE. (4) The first $2,000 in QEE create a $2,000 credit, and the next $2,000 create a credit equal to 25% of QEE in excess of the first $2,000. In total, $4,000 in QEE can result in a $2,500 credit, of which the first $1,500 is nonrefundable and the remaining amount, up to $1,000, is refundable. (5)

General tax treatment of scholarships

Sec. 117 specifies that scholarships and grants used to pay tuition and fees can be excluded from gross income; therefore, scholarships and grants not used for tuition and fees are included in gross income. Many colleges and universities will apply all scholarships and grants to a student's tuition and fees, and next to room and board, and then refund the remainder to the student to use for personal expenses. After the conclusion of the calendar year, the school issues Form 1098-T, reporting the payments received for tuition and fees and the amount of scholarships and grants awarded. Thus, it is almost a foregone conclusion when the student's return (and if applicable, his or her...