Tax Treatment of Scholarships
Scholarships (and fellowships) are generally tax-free, whether for
elementary or high school students, for college or graduate students, or for students at
accredited vocational schools. It makes no difference whether the scholarship takes the
form of a direct payment to the individual or a tuition reduction.
However, for the scholarship to be tax-free, certain conditions must be satisfied. The
most important are that the award must be used for tuition and related expenses (and not
for room and board) and that it must not be compensation for services.
Tuition and related expenses. A scholarship is tax-free only to the extent it is
used to pay for (1) tuition and fees required to attend the school or (2) fees, books,
supplies, and equipment required of all students in a particular course. For example, if a
computer is recommended but not required, buying one wouldn't qualify. Other expenses that
don't qualify include the cost of room and board, travel, research, and clerical help.
To the extent a scholarship award is used for nonqualifying items, it is taxable. The
recipient is responsible for determining how much of the award was used for qualified
tuition and related expenses so as to be tax-free. You should maintain records (e.g.,
copies of bills, receipts, cancelled checks) that reflect the use of the scholarship
Scholarship award can't be payment for services. A scholarship isn't tax-free if
the payments are linked to services that your child performs as a condition for receiving
the award, even if those services are required of all degree candidates. Thus, a stipend
your child receives for required teaching, research or other services is taxable, even if
the child uses the money for tuition or related expenses.
Returns and records. If the scholarship is tax-free and your child has no other
income, the award doesn't have to be reported on a return. However, any portion of the
award that is taxable as payment for services is treated as wages, and the payor should
withhold accordingly. Estimated tax payments may have to be made if the payor doesn't
withhold enough tax. Your child should receive a Form W-2 showing the amount of these
“wages” and the amount of tax withheld, but any portion of the award that is taxable
must be reported, even if no Form W-2 is received.
Your child's award can have the following impact on these related tax issues:
(1) You should still get dependency exemption. Your dependency exemption for your child
shouldn't be threatened by the scholarship. To claim an individual as your dependent, you
must provide more than 50% of his support. Since education is a support item, to the
extent that education costs are paid by an outside source, the amount of support you are
providing could fall below 50%. However, a special rule provides that educational costs
covered by a scholarship (or fellowship) for a dependent who is a child of the taxpayer
(but not for other dependents) aren't included in the calculation of total support.
Example. Ellen's parents provide $8,000 towards her support and she
receives a $10,000 college scholarship. If the scholarship were included in Ellen's total
support, the parents' $8,000 wouldn't be more than 50% of her support ($18,000) and they
wouldn't qualify to claim her as their dependent. However, since the scholarship isn't
included in her support, the parents qualify.
(2) Any taxable scholarship amounts should increase your child's standard deduction. As
noted above, to the extent scholarship funds are spent on room, board, or other
nonqualifying expenses, the award is taxable. However, it is treated as “earned
income.” This means if the student is being claimed as a dependent by his parent, and
using the standard deduction he or she may qualify for a higher standard deduction.
If an individual is a dependent, his or her standard deduction is limited to the greater
of (a) $850 or (b) the sum of $300 plus the individual's earned income, for both 2007 and
2006. But the standard deduction can't be more than the regular standard deduction ($5,350
for single taxpayers for 2007; $5,150 for 2006). So even though part of a scholarship is
taxable, it may be “covered” by the standard deduction.
Example. Tim is a dependent of his parents. His only income is $3,000 he
received as part of a scholarship which is taxable because it was applied to cover his
costs of room and board. Since the $3,000 is treated as earned income, Tim is entitled to
a $3,300 standard deduction which reduces his taxable income to zero.
(3) The tax-free scholarship may limit other higher education tax benefits you or your
child may be entitled to. If your child receives a tax-free scholarship and his or her
higher education expenses also qualify for any of the following credits, deductions, and
exclusions, the expenses taken into account in computing any of these other benefits must
first be reduced by the tax-free amounts used to pay the expenses:
Hope and Lifetime Learning credits.
Deduction for higher education expense.
Deduction for interest on student loans.
Coverdell ESA distribution exclusion.
Qualified tuition (529) plan distribution exclusion.
Savings bond interest exclusion.
In other words, neither you nor your child may claim a credit, deduction, or exclusion
based on expenses paid with tax-free scholarship funds.