Error treating excess scholarship as earned income

[OldSchoolTax]

My son had 2022 scholarship funds in excess (by $9000) of his qualified expenses. He also had $2600 in earned income. These were reported on 1040 Line 8 (transferred from Schedule 1, Line 8r) and 1040 Line 1, of his return, respectively. His return indicates that he can be claimed as a dependent on another's return (mine).

The correct deduction (1040 Line 12) should be $2600 + $400 = $3000. Instead, TurboTax incorrectly calculated the deduction as $9000 + $2600 + $400 = $12,000. (Tax is owed on the unearned excess scholarship, but that amount does not figure into determination of the deduction in the way earned income does.)

I didn't catch that in real-time, but the IRS sent a nice note with an offer for us to pay the 10% tax (plus penalty and interest) on the $9000, and call it even.

[rjs]

TurboTax is correct. The IRS notice is wrong. (It does happen.) Taxable scholarship income is treated as earned income for calculating the standard deduction for a dependent. IRS Publication 501, page 23, says "For purposes of the standard deduction, earned income also includes any part of a taxable scholarship or fellowship grant."

Follow the instructions in the IRS notice for what to do if you disagree with it.

[rjs]

Here's some even stronger support. I would put this ahead of the statement from Publication 501. The Standard Deduction Worksheet for Dependents on page 34 of the IRS Instructions for Form 1040 says the following.

"Earned income includes wages, salaries, tips, professional fees, and other compensation received for personal services you performed. It also includes any taxable scholarship or fellowship grant. Generally, your earned income is the total of the amount(s) you reported on Form 1040 or 1040-SR, line 1z, and Schedule 1, lines 3, 6, 8r, 8t, and 8u minus the amount, if any, on Schedule 1, line 15."

[OldSchoolTax]

Yes, thank you! I do see that. Remarkably, it does seem to say that unearned income should be treated like earned income for the purpose of determining the deduction. As in, "How much earned income do you have if you consider unearned income to be earned income."

In any other context, Excess Scholarship is considered unearned income.

The linguist might find that to be obtuse, but standard fare for the IRS.

I certainly believe that it is worth pursuing.

[OldSchoolTax]

Excellent! Many thanks to you as well as the earlier respondent. And apologies for doubting the accuracy of TurboTax.

Now comes the decision as to whether it is worth $900 to interact with the IRS. Time-wise, maybe not, but in principle, having had the very helpful assistance of board members, it would seem ungrateful not to.

I'll post an update after a final determination. Could take a while!

[rjs]

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@OldSchoolTax wrote:

Remarkably, it does seem to say that unearned income should be treated like earned income for the purpose of determining the deduction.

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Not all unearned income is treated as earned income. Only taxable scholarship income specifically.

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@OldSchoolTax wrote:

In any other context, Excess Scholarship is considered unearned income.

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Not quite. Taxable scholarship income is also treated as earned income for determining whether a dependent is required to file a tax return. But for other purposes it is considered unearned income.

I think taxable scholarship income is the only type of income that gets this mixed treatment.