Scholarship Tax Rules Leave Students Confused, Smith Expert Says

A recent case at a free income‑tax preparation site highlights a little‑known gap in the U.S. tax system—one that routinely leads students to underreport taxable scholarship income, often without realizing it.

A college student arrived at a volunteer‑run site expecting a refund. Instead, the preparer calculated a small balance due, driven by several thousand dollars in scholarship funds that exceeded her qualified education expenses. Under Internal Revenue Code §117, the excess is taxable.

The student was skeptical. She returned home, used a major consumer tax‑software platform to prepare the return herself, and the result was very different: a refund, with no scholarship income reported at all.

When she returned the next day to challenge the discrepancy, the site coordinator wasn’t surprised. He had seen the pattern before.

Her experience reflects a broader structural issue, according to Samuel Handwerger, CPA and senior accounting lecturer at the University of Maryland’s Robert H. Smith School of Business, where he also serves as faculty advisor to UMD-affiliated TerpTax, the aforementioned volunteer-run site.

The problem begins with the form most students rely on, adds Handwerger, also faculty advisor to UMD’s Financial Wellness Center and Justice for Fraud Victims.

“The 1098‑T is not a computation form,” Handwerger explains. “It reports what the school billed and what it disbursed, but it doesn’t determine what’s taxable. That calculation is entirely up to the taxpayer.”

The form includes two key numbers:

Box 1: qualified tuition and related expenses billed

Box 5: scholarships and grants received

When Box 5 exceeds Box 1, some portion of the excess may be taxable. But the determination depends on factors the school does not track—such as required books, supplies, and equipment—and that the IRS does not receive from any third‑party source.

Handwerger notes that this creates a blind spot in the enforcement system.

“There’s no matching program for taxable scholarship income,” he says. “The IRS can match a W‑2 to wages or a 1099‑NEC to self‑employment income. But the 1098‑T doesn’t give them a number to match. Without that, the automated notices don’t fire.”

Consumer tax software often compounds the issue. Many platforms ask for Box 1 but never prompt users to evaluate whether any portion of Box 5 is taxable. If the software doesn’t ask, most taxpayers don’t know to volunteer the information.

The result, Handwerger says, is predictable. “Most students aren’t trying to hide anything. They simply don’t know the income might be taxable, and the system doesn’t force the question.”

At the TerpTax site, preparers walked the student through the rules, including the fact that qualified expenses can include required textbooks and materials not reflected on the 1098‑T. In some cases, those additional costs eliminate any taxable excess. In others, they do not.

The student ultimately chose to file her return independently.

Her decision underscores a broader reality: the U.S. tax system relies heavily on voluntary compliance supported by third‑party reporting. Where reporting is strong—wages, interest, dividends—compliance rates exceed 95%. Where no third‑party figure exists, compliance drops sharply.

Taxable scholarship income falls squarely into that gap.

For thousands of students each year, the 1098‑T provides an official‑looking form that answers none of the critical questions. Tax software often fails to surface the issue. And the IRS’s automated systems cannot detect unreported amounts.

Handwerger says the volunteers did exactly what they were trained to do: apply the law, explain the rules, and respect the taxpayer’s choices.

Whether those choices align with the law is another matter—one the current system is not designed to catch.