Are scholarships tax-exempt? Yes and no
SMITH BRAIN TRUST – When Maryland Smith’s Samuel Handwerger was a kid, his dad made use of a legal tax gimmick to reduce the income taxes he would have to pay on his portfolio income – his interest, dividends and gains on his investments. He did this by gifting these interest- and dividend-bearing investments to Sam so that Sam would pay the tax, but the tax would be based on Sam’s much lower tax bracket. The gifting was done under the then-existing Uniform Gifts to Minors Act, or UGMA, rules.
It was a clever – and entirely legal – loophole that Congress closed in 1986 with the creation of the so-called “kiddie-tax,” which prohibited children from using their lower rates on portfolio income.
Before Sam turned 18 his dad (conveniently) took back the money he had gifted to his son, probably not quite legally. “A lot of people did that back then,” says Sam Handwerger, now a lecturer in the department of accounting and information assurance at the University of Maryland’s Robert H. Smith School of Business. In addition to the tax change, under today’s Uniform Transfers to Minors Act, or UTMA, the banks won’t let parents take back their gifts, Handwerger explains. “Seems I was born a little too early,” he laughs
Today Handwerger helps guide an IRS Volunteer Income Tax Assistance (VITA) chapter at Maryland Smith, providing free tax return preparation for hundreds of undergrad and graduate students. Every tax season, he says, they handle a fair share of issues related to what’s commonly referred to as the “kiddie tax,” that 1986 change made by Congress, which basically knocks out the lower rate brackets on portfolio income for kids.
“I know that seems surprising that we are dealing with it here,” he says. “After all, we're talking about tax returns for college age students – not ‘kiddies’ living at home.”
But in addition to affecting most kids under age 18, the kiddie tax does affect full-time students ages 18 to 23. Moreover, the tax rate application was revised with the Tax Cuts and Jobs Act (TCJA) in 2017 creating more situations where the kiddie tax rates can hurt.
The scholarship issues
So, where the kiddie tax can and does become an issue on college campuses is with taxable scholarship income. “A lot of people come in and say they thought scholarships were not taxable,” says Handwerger. “Well, yes and no.”
Scholarships used for qualified expenses – such as tuition, fees, required books, supplies and equipment – are indeed tax-free. “However, a common misconception is that room and board also falls into the nontaxable exception,” Handwerger says. “These and other nonessential expenses do not. They are taxable.”
Handwerger, speaking frankly about his days as a practicing CPA, says the tax portion of a scholarship is generally not reported and must be calculated by the tax preparer. “I need not tell you how many CPAs are possibly a little bit less careful in making the computation, if even thinking about it, given that it is not reported,” he says, quickly adding, “I, of course, am the exception.”
With the revised Form 1098-T, used to report tuition and scholarships, it is going to be easier for everyone, including the IRS, to see whether taxable scholarship monies do exist.
It works like this: Form 1098-T Box 1 lists those qualified tuition costs. Box 5 lists the amount of scholarships received. “Now, if Box 1 is greater than Box 5, then no problem. There is most likely no taxable scholarship,” he says. “However, if Box 5 is greater than Box 1, there is most likely taxable scholarship money. And that money is taxable as unearned income and taxable at – you guessed it – the kiddie tax rates.”
Here’s where tax law starts to get dizzy. Yes, the taxable scholarship money is considered unearned for purposes of the kiddie tax, but it is actually considered earned for purposes of calculating the standard deduction allowed under the kiddie tax computation. And it’s considered unearned for purposes of calculating the support test within the kiddie tax determination. “‘What does all that mean?’ So glad you asked,” says Handwerger.
It means that the taxable scholarship increases the standard deduction of $1,100 otherwise allowed under the kiddie tax, he says.
“Thus, unless the student has taxable scholarship and other unearned income above $12,200 for 2019, chances are there is no kiddie tax effect. But for room and board, that $12,200 amount is borderline,” he says. “And we do see many taxable scholarships go easily above that amount.”
Call it Scholarships 101.
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