Let’s assume your child gets the following 1098-T:
• Box 1: Tuition and required books, i.e. qualified education expenses: $6000
• Box 5: Scholarships, paid directly to the school: $5400
• Let’s assume that these are the all the tuition and book expenses your child has and all the scholarships your child received.
• Your child had $7000 in expenses for room and board. These expenses are NOT included on the 1098-T.
• Your child had $2000 in other education-related expenses (e.g., computer, supplies, etc.). These expenses are also NOT included on the 1098-T.
• Your AGI is less than $160000 (married filing jointly) and you want to claim the AOTC. How to go about it?
The first thing to note is that the 1098-T/the issuing school does not make any assumptions about how the scholarships were used nor does it make assumptions about how the scholarships are treated for tax purposes. They don’t care and simply show the various $$$ buckets. It is YOUR/YOUR child’s responsibility on your/your child’s tax returns to come up with the legally correct and optimal tax treatment.
2nd thing to note is that you can claim only expenses for the AOTC that are in Box 1, NET of any scholarships that have been used EXPRESSLY for these expenses, i.e. net of any scholarships restricted to paying for tuition/books. Whether scholarships are restricted or unrestricted in their use is important. In my limited experience, most are unrestricted, but find out from the grantor of these scholarships what the terms are.
Lastly, scholarships used to pay for anything else but Box 1-type expenses, e.g. room and board, equipment or supplies (e.g. laptop) are taxable.
• Let’s assume. The $5400 in scholarships are completely RESTRICTED and are to be used only for tuition/books.
• This means you cannot use the scholarships for anything but Box 1 expenses ($6000)
• Using the scholarship for Box 1 expenses makes the $5400 in scholarships tax-free.
• However, this leaves only $600 to claim the AOTC against ($6000 - $5400).
• Thus, you would receive a tax credit of $600.
• Net net, since your child’s taxes are likely lower than what you get for AOTC, you are likely better off, when you look at both tax returns in aggregate (taxes paid by your child vs tax credit received by you). Whether you are indeed better off will depend on your specific tax situation.
• Scholarships are completely UNRESTRICTED.
• This means you can use the scholarships against the total of $7000 room & board and $2000 for other education-related expenses. This makes the scholarship taxable income and your child pays appropriate taxes on them (kiddie tax).
• But at the same time, you want to claim a maximum of $4000 for AOTC to receive a tax credit of $2500.
• The math then is:
o Apply $2000 of the scholarships against Box 1 expenses. These $2000 are tax-free and this leaves $4000 to claim the AOTC against ($6000 - $2000)
o Then apply the remainder, $3400, of the scholarships against room/board and other education-related expenses ($7000 + $2000) o your child’s tax return. These $3400 are taxable and your child pays the appropriate taxes (kiddie tax after deductions)
o Net net, since your child’s taxes are likely lower than what you get for AOTC, you are likely better off, when you look at both tax returns in aggregate. Whether you are indeed better off will depend on your specific tax situation.
I’ve modeled these scenarios in Turbotax for my child’s tax return. TT is set up nicely to handle this approach, since they ask you how much of the scholarships is to be treated as taxable income.
See also: https://www.thetaxadviser.com/issues/2018/may/counterintuitive-tax-planning-increasing-taxable-scholarship-income-reduce-taxes.html (note that kiddie tax aspects have changed a bit since then, but the basic approach still holds). Basically just as described above
Contrary to what was stated in the comments by littleadv, completely legitimate. No fraud, lying or cheating.
Note that there is also an interplay here with 529 disbursements. I’m not getting into this here.