Yes, the penalty is waived if the reason it was not used was because the student received a scholarship. You can enter the 1098-T and 1099-Q and the program will give you the amount the student needs to report on his return.
From what you describe, it looks like the student can apply the distribution to the expenses and claim the excess scholarship, or claim the distribution.
If you enter the forms on your return, you will have a 1099-Q worksheet that will tell you what to report on the student's return, as well as the scholarship amount. (switch to forms mode (top right) and look at the list of forms and worksheets on the left)
To enter on the student's return:
Click on Federal,,,Wages & Income,,,,scroll down to the last section "Less Common Income"
Scroll down to the last choice "Miscellaneous Income, 1099-A 1099-C" and Start
Scroll down to the last choice "Other reportable income" and Start
For the Description enter "Scholarship" and for the distribution "1099-Q"
Enter the amount of the income that must be claimed
Click Continue repeat for the distribution and click Done
ALSO, since you can't claim the education credits, be aware that the student can claim the non-refundable part of an Education credit if he does not claim himself AND you do not claim him.
To do this, you do not claim the child. The student also does not claim himself. In the Turbotax program he selects "Yes" "Someone CAN claim me" but "NO" "Someone WILL claim me"
IN THIS CASE he enters the 1098-T and 1099-Q into his turbotax program.
You don't lose the dependent's exemption, since there aren't any this year, but you might lose credits.
He might have to report more income to get the credit, but it might be beneficial to offset his tax.
You would need to see which way gives you the best break. It's just another option.
