Q. In form 8615 it uses only non--tuition scholarship income and then subtracts $2,300 (NOT $12,950) to get taxable income.
A. No, that's not what's happening on form 8615. Taxable income was previous calculated and she got the full $12,950 deduction. Form 8615 calculates the portion of the taxable income (after the 12950 deduction) that is subject to the kiddie tax. Scholarship is not considered earned income for the kiddie tax.
Q. Based on your criteria below - although my daughter (under age 24 and FT student) is providing more than half (almost all) her support through the scholarship she is still a dependent because scholarship is excluded?
A. Scholarships are not considered as the student supporting herself, even though some of the scholarship is taxable. It is third party support. She is not providing more than half her own support. So, she can be your dependent.*
Q. IRS does not allow IRA contributions on scholarship income.
A. That's true for undergrads. A special provision, in the law, allows grad students to make IRA contributions based on taxable scholarship.
Q. So, Is there a way to reduce her taxes (or taxable income)? Based on your explanations I guess she CANNOT?
A. Only the big one already explained. She gets to count scholarship as earned income when calculating her standard deduction.
*If she's your dependent, you can claim the American Opportunity Credit (AOC), on your return. But she will have to claim another $4000 of scholarship as taxable, to free up some tuition for the AOC. The AOC is worth as much as $2500 to you vs about $800 in tax to her
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There is a tax “loop hole” available. The student reports all his scholarship, up to the amount needed to claim the American Opportunity Credit (AOC), as income on his return. That way, the parents (or himself, if he is not a dependent) can claim the tuition credit on their return. They can do this because that much tuition was no longer paid by "tax free" scholarship. You cannot do this if the school’s billing statement specifically shows the scholarships being applied to tuition or if the conditions of the grant are that it be used to pay for qualified expenses.
Using an example: Student has $10,000 in box 5 of the 1098-T and $8000 in box 1. At first glance he/she has $2000 of taxable income and nobody can claim the American opportunity credit. But if she reports $6000 as income on her return, the parents can claim $4000 of qualified expenses on their return.
Books and computers are also qualifying expenses for the AOC. So, extending the example, the student had another $1000 in expenses for those course materials, paid out of pocket, she would only need to report $5000 of taxable scholarship income, instead of $6000
