Dependent got scholarships exceeding educational expenses - how to pay tax on that scholarship income

[eajcrawford]

College student child is my dependent.

Got 1098T and it shows her tuition and that her scholarships exceed what was paid in tuition.

At one point, Turbo Tax told me that the child had to file a tax return. Now it is not saying that. It's only telling me that we don't qualify for any education credit.

What do I do? How do I know if she needs to file a return and how to do that?

She got $6,588.67 over tuition.

[Hal_Al]

If that is her only income, she does not need to file a tax return.

You do not report his/her income on your return. If it has to be reported, at all, it goes on his own return. If your dependent child is under age 19 (or under 24 if a full time student), he or she must file a tax return for 2020 if he had any of the following:

1.          Total income (wages, salaries, taxable scholarship etc.) of more than $12,400 (2020).
2.          Unearned income (interest, dividends, capital gains, unemployment, taxable 529 distributions) of more than $1100.
3.          Unearned income over $350 and gross income of more than $1100
4.          Household employee income (e.g. baby sitting, lawn mowing) over $2100 ($12,400 if under age 18)
5.          Other self employment income over $432, including money on a form 1099-NEC

______________________________________________________________________________________________

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 he/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.

[eajcrawford]

That sounds great and I am thankful for your response.

Where did you get that information?

[Hal_Al]

Q. Where did you get that information?

A. The first parts can be found in the instructions for form 1040.

The "loop hole" is not some sinister scheme. From the 2019 form 1040 instructions (pg 95): “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, line 18c, and IRS.gov/EdCredit.  Page 16 of PUB 970 (2019) actually has examples of how to do the “loop hole”.

[hbl3973]

eajcrawford,

You may have some homework to do here.  The first thing to do is download IRS Publication 970 (2020 Publication 970 (irs.gov)) and read up on the American Opportunity Credit. (Here I am assuming your dependent student is an undergraduate in their first four years at college.)   In particular, read up on page 16 and 17.

There are a few points to understand and/or consider:

(1) Yes, scholarship income, that is the excess of tax-free scholarships over qualified educational expenses, is income taxable to the student. 

(a) For the purposes of computing the dependent's standard deduction, it is considered earned income. 

(b) However, for the purposes of the dependent "Kiddie Tax", it is considered unearned income.

(2) When tax-free scholarships exceed qualified educational expenses, they are considered to have paid all the qualified expenses already, so you have no out-of-pocket qualified expenses to claim for the credit.

(3) The cited pages in publication 970, though, give you some potential wiggle room.  Depending upon the stipulations of the scholarship, specifically whether it can be applied against non-qualified expenses such as room and board or for that matter rock concert tickets, it can be beneficial to shift some or even all of the scholarship total from tax-free to taxable.  As soon as the residual tax-free portion is reduced below qualified educational expenses, there are now out-of-pocket qualified expenses that can be claimed for the educational credit.

How much to shift depends upon a number of factors and probably needs to be determined by trial-and-error.  In almost every case the first $2,000 thus shifted reduces your own taxes and also reduces the sum of your taxes and your dependent's taxes.  (Of course this assumes that there were at least $2,000 of such expenses to begin with.) Beyond that, you can try a variety of values up to $4,000 and see what gives the best result for the sum of your tax plus your student's tax.

One final tip: Not all qualified educational expenses are reported on Form 1098-T.  So do run through the actual info on pages 13 and 14 to add stuff like course textbooks to what appears on the 1098-T before figuring scholarship income.

[eajcrawford]

We earn too much to qualify for the AOC.

[hbl3973]

eajcrawford,

Unfortunately, your student will still likely need to file a return and deal with Kiddie Tax.  If the student has no other unearned income than the scholarship income, he or she may well not owe any tax because the standard deduction is earned income plus $300 up to $12,400.  You do have the option of not claiming your student on your own return and letting him or her take the AOC if there is a possibility of shifting more of the scholarship into his or her income to free up qualified educational expenses.  You would have to experiment to see whether as a family you come out ahead.

[eajcrawford]

My understanding of the factors of whether I have to have her as a dependent is that I have to claim her because she pays less than 50% of her support, we support her, and she is under 24 and a full time student.

So I did not think that putting her as a dependent was optional.

[Hal_Al]

Yes, that's mostly correct.  What's not optional is her claiming independent.  If she qualifies as your dependent, she must check the box on her 1040 saying she can be claimed as a dependent.

There is provision, in the tax code, that  if the student actually has a tax liability, she is allowed to claim a non-refundable tuition credit. But then the parent must forgo claiming the student as a dependent, and the $500 other dependent credit.  The student must still indicate that she can be claimed as a dependent, on her return.

From everything you have described, this does not apply in your case.

[Seansoph22]

But TurboTax has no where for a student to add “unearned income-scholarship”! Just for w2s, etc. can you tell me how to do this? I keep finding these articles but no where to do the calculation.

thanks

[Hal_Al]

Q.  But TurboTax has no where for a student to add “unearned income-scholarship”

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.

The  way to enter grant income, in TurboTax, is at Deductions and Credits / Education / Expenses and Scholarships.  That will put it on line line 8r of Schedule 1.

After answering no to having a 1098-T, answer yes to qualifying for an exception (that gets you to the entry screens). You will have to go thru the whole education interview to get to the scholarship screen. At the scholarship screen, enter the amount of the grant. When asked if any was used for room and board, answer yes. Then enter the amount you want to be taxable (usually all of it), in the pop up box. R&B are not "qualified educational  expenses".  So, this is how you tell TT that it is taxable. Note the wording at that screen “or other expenses”. You didn’t have to literally use the scholarship for R&B. 

[Seansoph22]

Thank you sooo much. I will try this. The turbo tax “tax expert” said that either the parent takes it all or the student. I explained your previous answer, the same info I found on an accountant website and what I found from the IRS publication, but she didn’t accept it. 

[Seansoph22]

Question though: does my parent have to somehow make a notation or communicate somehow with the irs as box 5 combines all the grants and scholarships I have (11031 total) but only 2882 was “quailed” . The other  is not qualified (pell, etc.) so I’m listing 8148 on mine 1040 and 2882 would be my parents. Under this my parent would put 2882 as what was in box 5, but box 5 in reality states 11031. Will this cause a problem or red flag. Do we need to state something?

[Hal_Al]

 Pell grants are not non qualified just because they're Pell. 

We cannot answer your question or not know how much of your scholarships are qualified or not qualified until we know how much is in box 1 of the 1098-T. In addition to box 1, what other qualified expenses do you have (books, computer and other course materials. 

Are your parents claiming the American Opportunity Credit on their return?

[MonikaK1]

Your parents should have records available to support the amount claimed for any education credit on their return, in the event of an IRS audit. 

See this IRS presentation with examples illustrating the interaction of scholarships and tax credits. Families may be able to increase their total refund or reduce tax liability by paying some tax on their scholarships and increasing their tax credit. Students may choose whether to treat their scholarships as used for tuition and related fees (tax-free, but reduces expenses for credits) or as used for living expenses (taxable, but does not reduce expenses for credits). 

See also IRS Publication 970 for more information.