Tuesday, June 21, 2011

College Financial Aid and Taxes

College financial aid applications have appeared in the office. This is somewhat an annual exercise for us, but let’s take the opportunity to review the tax implications of financial aid.

First, don’t let the terms mislead you. For example, a student may receive a “grant”, a “scholarship” or a “fellowship.” With only this information, I cannot tell you what the tax consequence is going to be. There are two key issues here. First, does the recipient (or someone) have to pay the money back? If the answer is yes, you have a loan and there is no taxable income. Loans are generally not considered income, as there has been no addition to wealth.

Say you don’t have to pay it back. Second question: does the recipient have to work in order to receive it? If the answer is yes, then it doesn’t matter what it is called – grant, scholarship, fellowship or tuition reduction – the recipient has income. He or she can expect a W-2 at year-end. Now, this doesn’t mean that there will be federal tax due. It may be that the W-2 does not exceed the recipient’s standard deduction and personal exemption, for example. Or it may be that the recipient claims an education tax credit which more than offsets any federal tax.

By the way, the tax consequence does not drive-off the source of the money. The IRS is not concerned whether the financial aid comes from a government agency, a nonprofit or a corporation.

If the recipient does not have to repay or work, then the aid is nontaxable as long as:

(1) The recipient is a degree candidate

(2) The aid is restricted for tuition and related expenses OR the aid is NOT restricted for something OTHER THAN tuition and related expenses.

(3) The recipient has to actually incur tuition and related expenses, and those expenses have to exceed the financial aid.

There is a combination where the recipient does not have to repay or work and yet has taxable income. How? It’s not intuitive, I grant you.

Notice the language in (2) above: “tuition and related expenses.” What expense is not related? Room and board is the biggie here. To the extent that the recipient receives non-loan, non-W-2 financial aid AND the aid exceeds the cost of tuition, fees, books and supplies, the recipient has income. The translation is that aid for room and board is taxable.

Let’s use an example. Say that Meadow Soprano receives a scholarship to attend Big Name U. She receives $45,000 aid for the academic year, and she is not obligated to repay or work. Her tuition, fees books and supplies are $36,500. Meadow has $8,500 ($45,000 – 36,500) of taxable income.

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