I called the IRS with this question today for tax year 2015. Their answer was that if the scholarship reported on 1098-T is taxable, it needs to be reported on the return of the individual to whom the 1098-T is addressed. This is probably the student in most cases, as it always is for me.
Publication 970 for 2015, in two separate sections discussing coordination with Pell grants and other scholarships (pages 15 and 26), suggests "consider including some or all of the scholarship or fellowship grant in the student's income in order to treat the included amount as paying nonqualified expenses instead of qualified education expenses." Also this: "Thus, including enough scholarship or fellowship grant in the student's income to report up to $4,000 in qualified education expenses for your American opportunity credit may increase the credit by enough to increase your tax refund or reduce the amount of tax you owe even considering any increased tax liability from the additional income." Similar language occurs in several parts of those sections. So this seems to match the answer from the IRS. These same sections also make it clear, by distinguishing between 'you/your' and 'the student', that it is possible for the parent to claim the credit even though the student reports the income.
Here, then, is how I handle my situation:
1) I claim my son as a dependent because he qualifies and I choose to do so.
2) He has a scholarship that is large enough to cover all tuition and other expenses that qualify for the education tax credits, but it is not large enough to cover anything else. So this *can* be a tax-free scholarship.
3) As it stands, my Adjusted Qualified Education Expenses on form 8863 are $0 for him, because I had to "reduce the qualified educational expenses for each academic period by the amount of tax-free educational assistance", and I therefor receive no tax credit for him.
4) Even though the scholarship *can* be tax-free, I choose to report $4000 of it as taxable income on my son's taxes. Publication 970 and the instructions for form 8863 both suggest this as an option to consider. Note that some scholarships may explicitly require that the funds be
used only for tuition, books, and fees. If that is the case, this
strategy is not an option.
5) I can now claim $4000 of qualified expenses on for 8863 for him, because I used $4000 of the scholarship for non-qualifying expenses (room and board), and my own $4000 for qualifying tuition expense.
6) I get $2500 education tax credits on my taxes.
7) My son now needs to pay taxes on the $4000 of scholarship income. In our situation, he has no other income, so his tax liability is $0. In fact, the $4000 of taxable scholarship income is not even enough to require him to file a return.
