To get the result you want; first enter the 1099-Q for $3500 distribution ($1087 Earnings). When you enter the 1098-T, on your return, enter $3500 in both Box 1 and Box 5 (you adjust the box 1 amount because the remaining expenses have already been allocated to Sydney's 1099-Q). Do not enter any other expenses. That tells TTax that scholarship covered the expenses, so the 529 distribution is taxable, but the scholarship penalty exception applies.
This assumes you are not trying to claim a tuition credit too. Unless your income is too high, you should be claiming a tuition credit, even if Sydney has to pay some tax on her 529 distribution and/or her scholarship. The American Opportunity Credit only takes $4000 of tuition to get a $2500 tax credit.
