Q. Who has to claim excess scholarship as income on their taxes?
A. The student.
Scholarships that paid for non qualified expenses are taxable. Tuition, fees, books and computers are qualified expenses. Room & board (R&B) are not qualified expenses. If box 5 of your 1098-T is more than box 1, TurboTax will automatically treat the difference as taxable scholarship income unless you tell it differently.
There is a tax “loop hole” available to claim an education credit, for the parents of students on scholarship. 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 conditions of the grant are that it be used to pay for qualified expenses.
Using an example: Student has $20,000 in box 5 of the 1098-T and $5000 in box 1. At first glance he/she has $15000 of taxable income and nobody can claim the American opportunity credit. But if she reports $19,000 as income on her return, the parents can claim $4000 of qualified expenses on their return. The parents will get (up to) $2500 credit, but the student will only pay about $500-1000 more in tax (depending on the tax rate).
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 $18000 of taxable scholarship income, instead of $19000.
As others have said, the is not only legal but encouraged. From the form 1040 instructions: “You may be able to increase an education credit if the student chooses to include all or part of a Pell grant or certain other scholarships or fellowships in income.
