Education credits and scholarship

[Questionguy101]

Is there a rule to determine whether scholarship has to be used to offset tuition or living expenses (room and board) first?

Facts of a student in 2010:

Qualified education expenses: $8,000
Room and board expenses: $12,000
Scholarship received: $8,000
Parents paid: $12,000
He is a dependent of his parents in 2010.

If we assume the $8,000 education expenses was paid by the scholarship and the $12,000 room and board expense was paid by the parent's funds, the parents won't be able to get education credit.

But if we assume the $8,000 education expenses was paid by the parent's support and the scholarship was used to pay for the room and board, the parents will be able to get education credit.

The problem is that scholarship and parent's payments were lumped together to pay for the tuition and the room and board. Not even the school can tell the student exactly which is for which.

My question is: Do the student and his parents have the freedom to decide which way to go?

[Koss]

Allocation

See TTB page 12-7, under the heading Coordination With Other Education Benefits. The discussion and the example suggest that the student may choose how to allocate the scholarship money, provided that the terms and conditions of the scholarship do not expressly limit the use of the money to the payment of tuition.

However...

As noted in the discussion on page 12-7, allocating the scholarship to room and board expense has the effect of making the scholarship taxable to the student. Scholarship money that is used for nonqualified expenses is taxable to the recipient of the scholarship.

So this can get really complicated really fast. Depending on the income level and tax bracket of the parents, it may still be advantageous for the student to take the scholarship as income. In your case, you may want to allocate less than the entire $8000 to room and board.

Assuming for the moment that the student has no other income, you need to account for the fact that the student will not get a personal exemption (since he's claimed as a dependent), but he will get a standard deduction. The standard deduction for dependents has some sort of floor, or minimum, that I'm too tired to look up. But the maximum standard deduction for a dependent is the lesser of $5700 or his earned income. And guess what? For purposes of calculating the standard deduction for a dependent, a taxable scholarship is considered earned income.

No, really. It is. See Worksheet 20-1 on page 139 of Pub. 17 (page 141 of the PDF). Read the definition of earned income at the bottom.

So you have to play around with this, because there may be a point of diminishing return, i.e., a point at which the tax liability to the student exceeds the benefit to the parents...

Ummm... wait a minute... lemmee think about this...

Feels like there would be no benefit to allocating more than $4000 of the scholarship to room and board. At that amount, the parents will max out on the AOC... and the kid will have no tax liability (unless he has other income).

Hmmmm?

BMK

[Questionguy101]

BMK

The big question is: Does the IRS allow taxpayers to have the freedom to play with the numbers like that?

And would a tax preparer be putting himself in trouble if he helps his client to work out the "best scenario"?

[dtlee]

If scholarships are not restricted as to use, my answer would be "yes."

I have seen nothing that says that defines a method of allocation nor that restricts allocation to the manner least beneficial to the taxpayer.

As Burton indicates, this can get really complicated. Not only are scholarships treated specially, but Section distributions from 529 plans are treated specially (and you cannot take loans to dependents and payments made by others on a dependent's behalf for the Tuition and Fees deduction). I know several situations where detailed worksheets had to be submitted to the IRS to explain how education expenses were allocated among various costs. It appears that if nothing was taken twice (in those situations where it would have been ineligible to be taken twice) the IRS is accepting the explanation.

[Koss]

Agree with Doug

Pub. 970 contains a couple examples that are similar to the one presented in The Tax Book.

The analogy that comes to mind is the exception to the penalty for early distributions from an IRA that is available when the person had qualifying educational expenses. I know that's a totally different scenario, but my point is this: To qualify for the exception to the penalty, the only thing you have to show is that during the calendar year in question, the person had qualifying educational expenses. That gets them off the hook for the penalty, with respect to the amount of the educational expenses. You don't have to show that the funds from the IRA were actually used to pay those expenses, and it doesn't matter whether the distribution occurred before or after the expenses were paid.

Put another way: There are no tracing rules. It isn't FIFO; it isn't LIFO. This is not QuickBooks. The student probably should have a unified "account" for educational expenses and "income" (i.e., scholarships), but good luck with that. Some expenses are paid in cash, such as textbooks. Or they might be paid with the student's credit card. Then the parents turn around and pay the credit card bill. Room and board might be off-campus. Or it might be on-campus, billed by the school on the same statement as the tuition. And as we all know, the tuition statements can contain other nonqualifying expenses, such as a parking permit or a student health insurance premium.

What Doug is saying is: If it is challenged by the IRS, and you can break it down in a way that makes sense, even after the fact... it will probably fly.

BMK

[oceanlovin'ea]

I have no personal experience with tuition payments or scholarships so this is an opinion from what I have gathered doing tax returns.

Scholarship is to help with tuition, room and board, books and whatever else the scholarship allows. So I would see no harm in telling the school to take the payment for room and board from scholarship money. If some still owed, parents or student would have to pay it.
If it covered all of it and still some scholarship money left then it would go to the other items.

But it would seem that you should earmark or say this scholarship money is used to pay room and board. I think it can be separated like that.

Linda. EA

[Lion]

Unless

Unless the scholarship is issued for tuition only.