Seems like a silly question doesn’t it? How can voluntarily paying taxes on anything serve to reduce total taxes in any way? Paradoxically, in certain situations it can!

First, a bit of background.

The tax code says that scholarships and grants used to pay tuition and fees can be excluded from gross income and consequently are not taxable. On the other hand, scholarships and grants not used for tuition and fees, but used to pay other expenses, are taxable income to the recipient.

These same tuition and fees also may be eligible for certain nonrefundable and refundable education tax credits under the law. While nonrefundable tax credits can only be used if you have a tax liability, refundable tax credits can result in a refund even if there is no tax obligation.

The American opportunity tax credit (or AOTC), for example, can be claimed by someone who is an eligible student or who claims an eligible student as a dependent, therefore the credit can be claimed on a parent’s return if the student is a dependent.

However, none of the available credits can be claimed if the qualifying education expenses (referred to as QEE here on out) have been paid with tax-free scholarship and grant funds.

Herein lies the planning opportunity.

Most colleges and universities will apply all scholarships and grants to a student's tuition and fees, next to room and board, and finally refund the remainder, if any, to the student to use for personal expenses. This is the way they will report it to the student on the annual Form 1098-T issued by the school.

As a result, by default, taxpayers seeing this may assume that is just the way it is, and because the scholarships and grants were netted against the QEE, the available education tax credit may not be taken (or taken at a reduced amount) because the QEE was supposedly “paid for” by the tax-free scholarships and grants.

However, many scholarships and grants, including Pell Grants, do not require a student to first use the funds for QEE, but allow the student to use the money for either tuition or fees or for living expenses while enrolled in school. Further, the IRS has stated that taxpayers who have such unrestricted scholarships and grants have the option to disregard the school’s allocation!

Basically, the student has the option of first allocating the funds to room and board and other living expenses and not to the QEE. While this would cause the scholarship and grant money to be taxable to the student, it would leave the QEE eligible for the possible tax credit. In some cases, particularly if the student can be claimed as a dependent by a parent, the tax credit received may be more than the tax imposed on the student, meaning the family as a whole has a lower tax burden.

The IRS even shows this in IRS Publication 970. As it says, you compute the tax liability or tax refund with the scholarship or grant included in the income of the student who received it. The student is, in effect, designating that the scholarship or grant is being used for personal expenses, and is reportable as taxable income. Treating the scholarship or grant as being used for these expenses maximizes the amount of QEE available to compute the education tax credit on the student's return, or in the case of a student who is claimed as a dependent of his or her parents, on the parents' return.

As a side note, scholarship and grants included in income are considered “unearned income” to the student for purposes of the so called “kiddie tax”. While discussion of the kiddie tax is beyond the scope of this article, when computing the student’s possible tax burden, it may apply.

You then compute taxable income the default way, with the scholarship offsetting QEE. This lowers taxable income of the student but may limit the credit available to student or parents. Once you have computed taxes both ways, you simply choose the option that minimizes the family's total tax burden. In some cases, the savings can be in the thousands.

This type of planning opportunity demonstrates the hazards of DIY return preparation, including the use of self-help tax preparation software and low cost tax preparation services. Rarely will such adequately notify you of the possible alternative choices for reporting scholarships and grants on you or your dependents’ returns, much less walk you through how to make the calculations.

By the way, the above discussion of the AOTC refers to an eligible student. An eligible student for the AOTC is basically someone who is seeking a postsecondary degree, certificate, or other recognized postsecondary educational credential and is enrolled at least part time at a qualified educational institution. They must also have not completed their first four years of postsecondary education, not claimed the credit for more than four tax years, and not have a felony drug conviction at the end of the tax year.

Lane Keeter, CPA is Office Managing Partner of the Heber Springs Office of EGP, PLLC, CPAs & Consultants