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Go to school on tax-free scholarships

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in Small Business Tax

The IRS recently indicated that college athletes won’t be taxed on scholarships if they are treated as employees. But it doesn’t mean that tax-free treatment is automatic for scholarship recipients.

Strategy: Learn all the tax rules in this area. Although your child might be in line for a tax-free scholarship, you may be surprised to find that part or all of the award is taxable.

The same basic tax principles apply to both athletic and academic scholarships.

In a controversial ruling issued in March, the National Labor Relations Board (NLRB) said that scholarships granted to football players at Northwestern University constitute compensation for services performed. This raised the question of whether such scholarships could be taxable. But a new information letter from the IRS debunked that theory. It said that taxation of college scholarships would continue to be governed by Section 117 of the tax code. (IRS Information Letter 2014-0016, 4/9/14)

Key rules: Under Section 117, a scholarship is exempt from tax if you’re a degree candidate if it doesn’t exceed your expenses; isn’t designated or earmarked for other purposes (such as room and board), and doesn’t represent payment for teaching, research, or other services required as a condition for receiving the scholarship (unless an exception applies). So this exemption covers tuition and related fees and course-related expenses such as books, supplies, fees and equipment required to take courses at the school.

However, the IRS goes on to say that the following expenses are not covered by the tax exemption:

   • Room and board

   • Travel

   • Research

   • Clerical help

   • Equipment and other expenses not required for enrollment in or attendance at an eligible educational institution.

Example: Suppose your child is offered a $5,000 scholarship at the state university. Of this amount, $3,000 is for tuition and $2,000 is specifically earmarked for room and board. As a result, the $2,000 for room and board, or 40% of the overall award, would be taxable to your child.

When is a student considered to be a degree candidate? The student must

   (1) attend a primary or secondary school or pursue a degree at a college or university, or

   (2) attend an accredited educational institution that provides a program acceptable for full credit toward a bachelor’s or higher degree, or offers a program of training preparing students for gainful employment in a recognized occupation.

Tip: Weigh tax aspects of scholarship offers.

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