eajcrawford,
You may have some homework to do here. The first thing to do is download IRS Publication 970 (2020 Publication 970 (irs.gov)) and read up on the American Opportunity Credit. (Here I am assuming your dependent student is an undergraduate in their first four years at college.) In particular, read up on page 16 and 17.
There are a few points to understand and/or consider:
(1) Yes, scholarship income, that is the excess of tax-free scholarships over qualified educational expenses, is income taxable to the student.
(a) For the purposes of computing the dependent's standard deduction, it is considered earned income.
(b) However, for the purposes of the dependent "Kiddie Tax", it is considered unearned income.
(2) When tax-free scholarships exceed qualified educational expenses, they are considered to have paid all the qualified expenses already, so you have no out-of-pocket qualified expenses to claim for the credit.
(3) The cited pages in publication 970, though, give you some potential wiggle room. Depending upon the stipulations of the scholarship, specifically whether it can be applied against non-qualified expenses such as room and board or for that matter rock concert tickets, it can be beneficial to shift some or even all of the scholarship total from tax-free to taxable. As soon as the residual tax-free portion is reduced below qualified educational expenses, there are now out-of-pocket qualified expenses that can be claimed for the educational credit.
How much to shift depends upon a number of factors and probably needs to be determined by trial-and-error. In almost every case the first $2,000 thus shifted reduces your own taxes and also reduces the sum of your taxes and your dependent's taxes. (Of course this assumes that there were at least $2,000 of such expenses to begin with.) Beyond that, you can try a variety of values up to $4,000 and see what gives the best result for the sum of your tax plus your student's tax.
One final tip: Not all qualified educational expenses are reported on Form 1098-T. So do run through the actual info on pages 13 and 14 to add stuff like course textbooks to what appears on the 1098-T before figuring scholarship income.
