UNDERSTANDING SCHOLARSHIPS AND GRANTS

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1 UNDERSTANDING SCHOLARSHIPS AND GRANTS Scholarships/Grants and Fellowships What is a scholarship/grant and Fellowship? A scholarship/grant is generally an amount of money paid or allowed to, or for the benefit of a student at an educational institution to aid in the pursuit of studies. The student may be either an undergraduate or a graduate student. A fellowship is generally an amount of money paid for the benefit of an individual to aid in the pursuit of study or research Are Scholarships/Grants and Fellowships Tax- Free Many individuals feel scholarships/grants and fellowships are always tax-free. But this is not true, according to the IRS and Congress. Here is what is IRS says a tax-free scholarship/grant or fellowship is: A scholarship/grant or fellowship is tax free only if: You are a candidate for a degree at an eligible education institution, and You use the scholarship or fellowship to pay qualified educational expenses Now this sounds pretty straightforward. Reading the definition, it is clear that most students will be attending college or other forms of post-secondary educational institution in order to get a degree and whatever the institutions bills you is a qualified expense. Most individuals reading this explanation would come to the conclusion that the above statement is true. However, the statement is not totally true. You have to look into the IRS s definition a little further to find the correct answer.

2 For example: What Is A Qualified Educational Institution: An eligible educational institution is one that maintains a regular faculty and curriculum and normally has a regular enrolled body of students in attendance at the place where it carries on its educational activities. This definition covers almost all institutions that provide a course of study above high school. But what the definition is not telling you is the institution that is giving the education must also be qualified institution. A qualified institution is a place of learning that participates in the federal financial aid system. So if you attend a place of learning that does not provide or make available financial aid from the federal government it is NOT a qualified institution. Many schools fall in this category. Most are specialized schools such as computer training, car repair, hairdressers, real estate programs, insurance/security training etc. Now What Is Meant By Qualified Educational Expenses: Here is what the IRS says are Qualified Educational Expenses: For the purposes of tax-free scholarships/grants and fellowships, these are expenses for: Tuition and fees required to enroll at or attend an eligible educational institution and Course-related expenses, such as fees, books, supplies, and equipment that are required for the course at the eligible educational institution. These items must be required of all students in the course of instruction. If the scholarship/grant or fellowship is used for the items we just went over, the scholarship/grant or fellowship is TAX-FREE. Tax-Free scholarships/grants and fellowships are normally call QUALIFIED scholarships/grants and fellowships. However, if the scholarship/grant or fellowship dictates the funds cannot be used for tuition/fees and course related expenses the scholarship/grant or fellowship is now reclassified as a NON-QUALIFIED scholarship/grant or fellowship.

3 What Are Non-Qualified Expenses: Expenses that are not qualified are as follows: Room and Board Travel Research Clerical Help, or Equipment and other expenses that are not required for enrollment in or attendance at an eligible education institution This is true even if the college or university requires you to pay for these items as a condition for enrollment or attendance and you pay the institution directly. Now the IRS says the above items are not qualified expenses for the tax-free treatment of scholarships/grants or fellowships, but how is the student able to get a degree WITHOUT living somewhere, traveling to the institution, and purchasing needed equipment (computer, calculators, etc.)? Well, the IRS and Congress has come to the conclusion, that the student can live with a relative or parents and not on campus. They also believe the travel to the institution is a personnel expense. They also have come to the conclusion that computers, calculators, etc. are not necessary equipment that needs to be bought, even if the professor tells the student they need the computer or calculator to take the class. The IRS and Congress think the student can get access to these items at the library or borrow them from a classmate. Now here is where it really gets ridiculous. If the college or institution REQUIRES ALL students that are taking a course of study MUST purchase special equipment (computers, calculators, etc.), then the purchase of these items now have been reclassified as Qualified Educational Expenses and scholarships/grants or fellowships can be used to purchase these items and will be Tax-Free to the student. Athletic and Other Scholarships Most student-athletes and their families feel athletic scholarships are always taxfree. However, this is not true. If your son or daughter were to receive an athletic scholarship in an amount that paid for tuition and fees, room/board, books/supplies, and miscellaneous expenses, two thirds of the scholarship would be TAXABLE to the student-

4 athlete in the year the funds were received. According to the IRS and Congress, an athletic scholarship is only tax-free when used to pay for QUALIFIED expenses that we just covered in this publication. These same rules apply to ANY scholarship that the student may receive that is used to pay educational expenses. Now let s look at how Taxable Scholarships/Grants or Fellowships are looked upon by the IRS and Congress. Taxable Scholarships/Grants and Fellowships As I have just mentioned above, if the student were to use scholarship/grant or fellowship monies to pay for Non-Qualified expenses, the funds are taxable to the student in the year they are received. Let s look at the definition that is given in Publication 970 on the taxation of scholarships/grants or fellowships. Amounts used to pay expenses that do not qualify as necessary expenses Payments for services Scholarship Prizes If your scholarship/grant or fellowship does not meet the requirements described earlier, it is taxable to the student. Amounts used to pay for non-qualified expenses is taxable to the student, even if the expenses are fees that must be paid to the college or university as a condition of enrollment or attendance. An example of these fees are: Student Activity Fees Parking Fees Library Fees, etc. Scholarships/grants or fellowships that are used to pay for educational expenses that represents payments for PAST, PRESENT, or FUTURE teaching, research, or other services is taxable compensation to the student in the year it is received. Here is an example from Publication 970.

5 Example From Publication 970 You are a candidate for a degree at a medical school. You received a scholarship for your medical education and training. The terms of the scholarship require you to perform future services from the donor of the funds. A substantial penalty applies if you do not comply with the arrangement. The amount of the scholarship/grant is taxable to the student in the year it is received. The above explanation applies to ALL occupations. One of the best explanations I can give, deals with the occupation of nursing. Many hospital give nursing scholarships to student in order to fill the nursing shortage that many hospital are encountering. Normally these scholarships are given to the student with the understanding, upon graduating, the student will work several years for the hospital in exchange for the educational assistance. If the student does not complete their education, the hospital will require the student to repay the scholarship money in a lump sum or repay the money (with interest) over a negotiated time period. Scholarship Prizes Scholarship prizes normally are scholarships that are won in a contest. These scholarships usually are given directly to the student. This is unlike many scholarships of which the check is written out to both the student and the college/university. The student winning the scholarship prize can use the funds for any purpose they choose, such as cloths, computers, travel, senior prom, etc. However, if the student uses ALL the funds to pay for qualified educational expenses, the scholarship would qualify for tax-free treatment under IRS guidelines. In order to see if the scholarship/grant or fellowship is taxable or tax-free complete the worksheet on the next page that is provided by the IRS. Worksheet 1-1. Taxable Scholarship and Fellowship Income 1. Enter your scholarship or fellowship income for If you are a degree candidate at an eligible educational institution, go to line 2. If you are not a degree candidate at an eligible educational institution, stop here. The entire amount is taxable. For information on how to report this amount on your tax return, see Reporting Scholarships and Fellowships.

6 2. Enter the amount from line 1 that was for teaching, research, or any other services. (Do not include amounts received for these items under the National Health Service Corps Scholarship Program or the Armed Forces Health Professions Scholarship and Financial Assistance Program.) Subtract line 2 from line Enter the amount from line 3 that your scholarship or fellowship required you to use for other than qualified education expenses Subtract line 4 from line Enter the amount from line 5 that was used for qualified education expenses required for study at an eligible educational institution. This amount is the tax-free part of your scholarship or fellowship income* Subtract line 6 from line Taxable part. Add lines 2, 4, and 7. See Reporting Scholarships and Fellowships for how to report this amount on your tax return 8. Reporting Scholarships/Grants or Fellowships After completing the worksheet above and you find all or part of your scholarship/grant or fellowship is taxable, how do you report this additional income on the student s tax return? From Publication 970 Whether you must report the scholarship/grant or fellowship depends on whether you must file a return and whether any part of the scholarship/grant or fellowship is taxable. If your only income is a completely Tax-Free scholarship/grant or fellowship, you do not have to file a tax return and no reporting is necessary. If all or part of your scholarship/grant or fellowship is taxable and you are required to file a tax return, you must report the taxable amount. You must report the taxable amount whether or not you received a Form W-2. Here is an overview of how to report scholarships/grants or fellowship income: Generally, the student will only receive what is called a 1098-T from the college or university. The 1098-T will show the student the amount of the scholarships/grants or fellowships the student received during the academic year and will also list the amount of Qualified Expenses that was incurred. Below is an explanation on how to report the income.

7 How To Report From Publication 970 Form 1040EZ. Report the taxable amount on line 1. Enter SCH and the taxable amount in the space to the left of line 1 Form 1040A. Report the taxable amount on line 7. Enter SCH and the taxable amount in the space to the left of line 7 Form Report the taxable amount on line 7. Enter SCH and the taxable amount on the dotted line next to line 7 If you file Schedule SE (Form 1040), Form 1040NR, or FormNR-EZ check with your tax preparer or CPA for further instructions. Compliments of College Advisors Group For a Free consultation please call ext 12 and ask for Gayle. College Advisors Group mission is to students and parents prepare and pay for college tuition without devastating their other financial goals. Call us to see if we can be of assistance. (P) (F) (E) [email protected]