All facts you re-stated are correct.
RE:
Q. The $15K distribution used to pay for qualified expenses, should be tax-free and penalty-free. Am I correct?
A. No. It appears it was covered by scholarship.
Withdrawals/distributions from 529 to match the scholarship amount received are NOT subject to a 10% penalty, but we still have to pay taxes on earnings (interest).
Q. Can we only declare earned income on the scholarship amount we did not get 529 distribution?
A. No, you can re-allocate funds and expenses as needed.
Can we claim the entire $25K withdrawal/distribution from 529 as his earned income? What are the benefits of reallocating funds as earned income vs paying taxes on income earned on $25K?
Are you eligible for the AOTC (is your income not too high)?
No, my wife and I do not qualify.
Is any of the scholarship restricted? That is, must it be used for certain expenses (usually tuition)?
The scholarship received has no restrictions.
Is the student your dependent?
Yes, but we're planning not to claim him.
I assume the student is a full time undergrad.
Yes, he is a full-time undergrad.
