Rules for Exemptions in Taxability of Scholarships
When it comes to taxability of scholarships, it's better to find out well before your taxes are due rather than at the last minute whether or not your scholarships need to be accounted for on your tax forms.
If the student is not a degree candidate, the full amount of any financial aid is subject to federal income tax, even if it is spent on educational expenses.
If the student is a degree candidate, then scholarship and fellowship amounts used for tuition and REQUIRED course-related expenses (e.g., fees, books, supplies, and equipment) are exempt from federal income tax and may be excluded from gross income. Amounts used for living expenses (room and board) and other non-required expenses (computers, travel, etc.) are not exempt.
In most circumstances, federal and state educational grants are not taxable. (They are treated as scholarships, and are nontaxable to the extent that they were used for tuition and education-related expenses. Since most federal and state educational grants are restricted to being used for tuition, the usually end up being nontaxable.)
Student loans are also not taxable. If all or part of a student loan is cancelled or forgiven, the amount of debt forgiven may represent taxable income. See IRC section 108(f) for details.
Not Payment for Services
The scholarship or fellowship must NOT, however, be awarded in compensation for teaching and research services performed by the student. The portion of the award that represents payment for services is taxable. For example, a teaching assistantship or research assistantship is not necessarily exempt. If you are required to teach a class in exchange for your tuition waiver and stipend, it may be the case that the award is fully taxable. In such cases, for the tuition waiver portion of a TAship or RAship to be exempt, the rest of the stipend must represent fair compensation for the services rendered. Stipends paid for living expenses are, of course, always taxable. If the tuition waiver is exempt, then only the stipend portion of your award will be reported to you (and the IRS) as income on your W2 form.
Some universities or departments work around the "payment for services" restriction by making teaching duties part of the educational program. For example, one department provides every graduate student in the department with a full fellowship, and requires each graduate student to TA two classes before they can graduate. Since the teaching and research duties are uniform for all students and are construed as educational requirements -- more for the benefit of the student than the university -- these duties do not represent payment for services. They are graduation requirements and not conditions for receiving the grant. These duties are an essential part of the students' graduate education; TAships provide the student with teaching experience necessary for their future careers as faculty, and RAships provide the student with the opportunity to conduct doctoral research and to work on their dissertation. After all, a PhD is a research degree, so it makes sense to require research experience as part of the degree program.
[The IRS recently started challenging the validity of such arrangements. According to the May 5, 1995, issue of the Chronicle of Higher Education, the IRS has asked the University of Wisconsin at Madison for $81 million in back taxes, claiming that the work performed by research assistants is not part of their graduate education and hence subject to taxation like any other job. Note that the university was careful to distinguish between research assistantships intended to further the student's education and research assistantships aimed at assisting faculty with their own research. Federal income tax and Social Security tax was withheld from the latter but not the former. The university will be fighting the charges in US Tax Court.]
ROTC and Service Academies Exempt
ROTC scholarships and the service academies are specifically exempted from this requirement in the tax code, even though they could be considered payment for services. So the tuition, books, and the monthly stipend students receive from ROTC are exempt from tax. Pay for summer training, however, is taxable, and the student will receive a W2 for this work. (Veteran's educational benefits, however, may be taxable. Check with the VA for more information.)
Definition of Excludable
Excludable expenses are eliminated from gross income before any deductions. Thus you can exclude the exempt amounts and still take advantage of the standard deduction. Note that if you itemize your deductions, you cannot both exclude the educational expenses from gross income and deduct them -- no double dipping.
Scholarships and Fellowships Exempt from Social Security Taxes
The full amount of a scholarship or fellowship is usually exempt from FICA (social security) whether or not the student is a degree candidate.
Moving Expenses Not Deductible
Many new graduate students ask whether their moving expenses are tax deductible. Unfortunately they aren't, according to the IRS, because graduate students aren't really employees.
Universities are not required to report scholarship or fellowship income for US students to the IRS via W2 or 1099 forms, nor do they have any responsibility for withholding estimated tax for these students. The only exception is assistantships where the compensation represents pay for services and must be reported on a W2. (According to IRS guidelines, students who receive pay for services should receive a W2 form, not a 1099 form.)
For foreign students, however, the university is required to withhold appropriate taxes. (Many universities are too conservative in the amount withheld, so foreign students should cite the terms of the appropriate tax treaty on their return to claim a refund of the excess taxes withheld.)
If you received a taxable scholarship or fellowship which was not reported to the IRS on a W2 or 1099 form, you are required to include it on line 7 and write "SCH" to the left. If you report taxable scholarship or fellowship income in this fashion, it is wise to attach an explanatory letter to your return, especially if you exclude any required educational expenses.
If your scholarship or fellowship was reported to the IRS on a W2 or 1099 and you wish to exclude additional required educational expenses (e.g., the university excluded tuition and fees but not required books), exclude the amount of the expenses from the amount reported on line 7 on Form 1040 or Form 1040A and line 1 of Form 1040EZ, and attach an explanatory letter. It is very important to attach such a letter, since the IRS computers will notice the discrepancy between the amounts reported to the IRS and the wages you listed on your return. Failing to attach such a letter will likely cause your return to be audited. (Some people recommend reporting educational expenses as a negative amount on the "Other Income" line, instead of subtracting the expenses from line 7. In either event, you should still attach an explanatory letter.)
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