What is the tax rule for Scholarship for Service?

[5Beverly]

If a college students gets the scholarship for service from an organization, that means he got scholarship now, but have to work for the same amount of years for the agency after he graduate. Which part is qualified for tax free? For the part he has to pay tax, what if he changes his mind and return the money to the organization when he graduates,  how can he get the paid tax back?

[AmyC · Accepted solution]

None of it is tax free, if your situation matches Example 2 below. If the money ends up being repaid, there is an IRC 1341 for repayment of income received. This tax return will need to be kept as it may become the basis for the credit of the future tax return. See page 36 About Publication 525, Taxable and Nontaxable Income

IRS Pub 970 states:

Payment for services.

Generally, you can't exclude from your gross income the part of any scholarship or fellowship grant that represents payment for teaching, research, or other services required as a condition for receiving the scholarship. This applies even if all candidates for a degree must perform the services to receive the degree. However, see Exceptions next.

Exceptions.

You don't have to treat as payment for services the part of any scholarship or fellowship grant that represents payment for teaching, research, or other services if you receive the amount under:

• The National Health Service Corps Scholarship Program,

• The Armed Forces Health Professions Scholarship and Financial Assistance Program, or

• A comprehensive student work-learning-service program (as defined in section 448(e) of the Higher Education Act of 1965) operated by a work college (as defined in that section).

Example 1.

You received a scholarship of $2,500. The scholarship wasn't received under any of the exceptions mentioned above. As a condition for receiving the scholarship, you must serve as a part-time teaching assistant. Of the $2,500 scholarship, $1,000 represents payment for teaching. The provider of your scholarship gives you a Form W-2 showing $1,000 as income. Your qualified education expenses were at least $1,500. Assuming that all other conditions are met, the most you can exclude from your gross income is $1,500. The $1,000 you received for teaching must be included in your gross income.

Example 2.

You are a candidate for a degree at a medical school. You receive a scholarship (not under any of the exceptions mentioned above) for your medical education and training. The terms of your scholarship require you to perform future services. A substantial penalty applies if you don't comply. The entire amount of your grant is taxable as payment for services in the year it is received.

[5Beverly]

Thank you very much for your help. I misunderstood the the nature of the scholarship. My son double checked with the school.  It is actually loan for services agreement based on the government document. But if he works for the government for the amount of years he singed up for, the loan will be forgiven, otherwise, he has to repay back as a loan. Does that change the TAX situation?

[AmyC]

Yes, a loan is not taxable income. Good for him!

[5Beverly]

Thank you very much for the help. That is great to know he does not pay tax for the "loan for service" now. Does he needs to pay that in the future if it is discharged?

[AmyC]

If he chooses not to work, he would repay the loan. If it counts as a college loan (which would be rare), the interest would be deductible, otherwise, no deduction allowed. If he chooses to work, the loan is paid and there is no tax consequence.

[5Beverly]

You are really so helpful! We appreciate it a lot. I hope this is the last question about it. In that case,  what should I enter for his tuition paid and scholarship in TurboTax?

[AmyC · Accepted solution]

That is the hardest question! I don't know what forms, what amounts are in the boxes, undergrad, etc! The loan has no effect on tuition paid or scholarships.

Let's assume:

• parent claiming
• undergraduate, which qualifies for 4 years of AOTC- if you are eligible.

AOTC  eligibility

$80,000-$90,000

$160,000- $180,000 MFJ

The AOTC is worth up to $2,500 per student for the first $4,000 you spend on qualifying educational expenses on behalf of you, your spouse, or your dependents. 

Then look at 1098-T from college.

Ex 1 Box 1 bigger than box 5 by $4,000 or more. Great, enter it.

Ex 2 Box 5 bigger than box 1

• Box 1 $15,000
• Box 5 $20,000

Options are:

• Lower income, bigger tax bill. Make $5,000 taxable income to student and nobody gets education credit
• Higher income, lower tax bill. Mark part of box 5 used for room and board and other expenses,  Pick any reasonable number, say $8,000. This leaves $3,000 for education credits to be claimed. $8,000 goes into taxable student income. Education credit is claimed on $3,000. This is much, much better financially.

Available Education Credits

IRS Q & A about education credits

Tax Benefits for Education: Information Center| IRS

Glad to help, good luck!