Q. She'll need to add the $2,742 amount on her tax return as it acts as taxable income?
A. That is correct.
Q. In the end, she made barely 3,900~ which is under the $13,850 gross income. Does she have to file?
A. No. As you said, her income* is less than the filing requirement. But she is allowed to file if she wants her $15 back.
Q. We put her info into TurboTax and it says she's qualified for $15, which is what they withheld from her paycheck?
A. That sounds correct.
Q. I am not eligible for any credits as box 5 exceeds box 1?
A. Maybe not.
There is a tax “loop hole” available. The student reports all his scholarship, up to the amount needed to claim the American Opportunity Credit (AOC), as income on his return. That way, the parents (or himself, if he is not a dependent) can claim the tuition credit on their return. They can do this because that much tuition was no longer paid by "tax free" scholarship. You cannot do this if the school’s billing statement specifically shows the scholarships being applied to tuition or if the conditions of the grant are that it be used to pay for qualified expenses.
Using an example: Student has $10,000 in box 5 of the 1098-T and $8000 in box 1. At first glance she has $2000 of taxable income and nobody can claim the American opportunity credit. But if she reports $6000 as income on her return, the parents can claim $4000 of qualified expenses on their return.
Books and computers are also qualifying expenses for the AOC. So, extending the example, the student had another $1000 in expenses for those course materials, paid out of pocket, she would only need to report $5000 of taxable scholarship income, instead of $6000.
In her case, she is still under $13,850 and technically still does need to file a tax return. But you may want to file anyway, just to document the reporting of scholarship income for the loop hole.
*Scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $13,850 filing requirement and the dependent standard deduction calculation (earned income + $400). It is not earned income for the kiddie tax and other purposes (e.g. EIC). For grad students and post grad fellows, scholarship, stipend and fellowship income is earned income ("compensation") for IRA contributions.
The IRS actually encourages use of this technique. From the form 1040 instructions: “You may be able to increase an education credit if the student chooses to include all or part of a Pell grant or certain other scholarships or fellowships in income. For more information, see Pub. 970, the instructions for Form 1040 and IRS.gov/EdCredit". PUB 970 even has examples of how to do the “loop hole”.
