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 degree (4) at a qualified educational organization. (5) Qualified tuition and related expenses in this case include required tuition, fees, books, supplies, and equipment.
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)
Exceptions for athletic or other scholarships that require services to be performed
Athletic and certain other scholarships that require effort from the participant, such as those that require students to be in musical ensembles, have historically not been included in gross income because of Rev. Rul. 77-263. This IRS ruling is based on the U.S. Supreme Court's decision in Bingler v. Johnson (11) and the Tax Court case Heidel. (12) In Bingler, the Supreme Court held that compensation exists if there is a quid pro quo relationship between the parties. In other words, a person receives a payment only in response to an action the recipient produced, whether in the past, present, or future. Heidel involved a student who would continue to receive the scholarship even if the student did not actually participate in the sport because of injury or even a lack of desire. According to the Tax Court, receiving a scholarship with no strings attached does not meet the quid pro quo test and therefore qualifies to be excluded from gross income under Sec. 117.
Whether athletic or similar service-based scholarships still qualify under the no-strings-attached test is debatable, but at this point the IRS has chosen not to press the issue. Assuming there is no change in treatment for these scholarships, they would be treated like any other qualifying scholarship. However, the authors believe that if the IRS were to push the issue, especially for athletic programs of larger schools where it is not uncommon for student athletes to receive full tuition, room and board, and possibly other funds for their service in the athletic program, a court might find that the holding in Bingler did not apply. Many of these programs would likely stop providing a scholarship to any student who decided to no longer participate in the activity, demonstrating the quid pro quo relationship and the conditions that are inherently attached to the...