Scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $12,950 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 income is earned income ("compensation") for IRA contributions.
Q. On Form 8615, is the unearned income on line 1 supposed to include the interest AND the scholarship?
A. Yes. It's the gross unearned income, before the calculation of taxable income.
Q. Taxable income from the 1040 would be $12K-$10K (because scholarship is earned for calculating the standard deduction). Does that mean the $1600 (which is basically the interest less the $400 deduction) is subject to the kiddie tax?
A. Yes
Q. Does that mean that if a student has a taxable scholarship greater than a pretty minimal amount plus additional unearned income, then the $2300 kiddie tax deduction never really comes into play?
A. No. It just means the calculation is different, since the dependent's taxable income is less than their unearned income after the $2300 deduction. In your example, the kiddie tax is only applied to the $1600, instead of the $5700. Another way to look at it is: you're still getting the full $2300 kiddie tax deduction, it's just shown/applied somewhere else (in the increased standard deduction).
Q. It just seems unfair that in my example you would not pay kiddie tax on the $1600 of interest if the interest was your only unearned income, but that you do pay kiddie tax on the $1600 of interest if you have taxable scholarships (even though those scholarships aren't actually taxed as long as below the standard deduction).
A. Others might argue that it's unfair that your unearned income is treated better than their unearned income. In your example, $8000 of unearned income is taxed as if it's only $1600.
