Q. Can I choose to consider those OOP expenses on my return in order to claim some AOTC, and have my DS pay tax on the scholarship?
A. Yes.
Q. Must I reduce the amount of taxable scholarship by ALL of the qualified expenses (either on 1099-T or not)?
A. No, unless it is a condition of the scholarship that funds be used for those qualified expenses. It would be unusual for the scholarship to to require that on non 1098-T fees.
Q. Is the application of scholarship vs. OOP funds even an option/choice?
A. Yes, except when it's a condition of the grant.
Q. I think DS would be exempted from the first $1100, pay $0 tax on the next $1100, and then pay my marginal tax rate 22% on the remaining ~$4800 = ~$1056 tax (??)
A. Generally correct, except the 2nd $1100 is taxed at 10%, not 0%. But it gets better. A Dependent student (DS) is allowed a standard deduction of $1100 (hence the first $1100 being "exempt") or his earned income + $350. For purposes of calculating the standard deduction, scholarship income (but not taxable 529 or prepaid plans) is treated as earned income. So if a DS had $6600 taxable scholarship, none of it would be taxable as his standard deduction would be $6950. So, having taxable scholarship is usually better than having a portion of the 1099-Q be taxable, on the student's return.
