Scholarship is unearned income for the purposes of the kiddie tax

The kiddie tax was added by the 1986 Tax Reform Act to prevent parents in higher tax brackets from avoiding tax on income from investment assets by transferring them to their children. 

In 2006 and 2007, the law was amended so that the kiddie tax now applies to dependents up to age 18 and up to age 23 if they are full-time students. Consequently, the taxable portion of college scholarships may be unearned income and subject to the kiddie tax.

In 1986, this was not a material issue because, when it was enacted, the law applied only to children under 14 years of age. Now that the age has been raised to children under 24 for certain full-time college students, the blessing of a scholarship may come with an unanticipated tax shock and requires CPAs to consider this wrinkle in tax planning. Beginning with 2013 returns, the IRS changed the title of Form 8615 from Tax for Certain Children Who Have Investment Income of More Than $1,900 to Tax for Certain Children Who Have Unearned Income. Similarly, the instructions for the form were changed to include taxable scholarship and fellowship grants not reported on Form W-2, Wage and Tax Statement.

To be clear, Sec. 117 allows scholarships for tuition and fees required for attendance and other fees and expenses required for courses to be excluded from federal income tax, including the kiddie tax. However, scholarships that help defray the other costs of attendance, such as room and board, were and continue to be taxable.

Taxpayers may be confused by the application of the kiddie tax to scholarships because Sec. 63(c)(5) (the standard deduction for dependents), Sec. 6012 (persons required to file a return), and Prop. Regs. Sec. 1.117-6 (qualified scholarships) all treat the taxable portion of scholarship income as earned income.

- See more at:https://www.irs.gov/taxtopics/tc553.html