Voluntarily treat scholarships as taxable income to get AOTC?

Question

Our AGI is less than $160K and we therefore qualify for the AOTC for our child's college education.

However, due to scholarships our child receives and that are paid directly to the school, qualified education expenses paid out of pocket (i.e. not funded by a 529 disbursement) are likely only about $600 for the fall semester (we don't have the 1098-T yet, obviously), significantly limiting the AOTC we can take ($2000/2500 for $2000/$4000 in QE). However, she does have significant expenses for room and board, computer etc.

Is it possible to treat a scholarship paid directly to the school as taxable income (e.g. by applying it to the non-qualified room and board expenses) on my child's tax return in order to increase qualified education expenses (the net of tuition/books and scholarships) and to take maximum advantage of the AOTC?

Looking at the child tax return (pay a bit more taxes) and parent tax return (pay significantly less taxes) as a whole, this strategy could yield net tax savings.

What else do I need to consider?

(I realize that applying the AOTC in a different year is also an option, but that's not what I'm after.)

Answer 1

The main point of contention appears to be the following question:

Is it possible to treat a scholarship paid directly to the school as taxable income (e.g. by applying it to the non-qualified room and board expenses) on my child's tax return

As you have already found, "Publication 970 (2021), Tax Benefits for Education" is quite clear that yes, one can. This is described explicitly in the following example [emphasis mine]:

Example 4—Scholarship applied by the postsecondary school to tuition.

The facts are the same as in Example 3—Scholarship partially included in income, except the $5,600 scholarship is paid directly to the local college. The fact that the local college applies the scholarship to Bill's tuition and related fees doesn't prevent Bill from including $4,000 of the scholarship in income.

A similar situation also arises in this example, though it is not directly relevant to your question:

Example. In 2021, Ms. Allen makes a payment directly to an eligible educational institution for her grandson Todd's qualified education expenses. For purposes of claiming an American opportunity credit, Todd is treated as receiving the money from his grandmother and, in turn, paying his qualified education expenses himself.

Another user contends that this is fraud and a misrepresentation of the actual situation. They ask for a reference to a law or regulation allowing this, with the qualification that an IRS publication is not legal authority. While I have personally favorably resolved a dispute with the IRS regarding whether a scholarship was taxable income, I am not a tax lawyer nor accountant [and insert any other necessary qualifiers here]. Nonetheless, I believe this user in incorrect. Specifically, 26 CFR [IRC] § 1.25A-5(c)(3) states the following [emphasis mine]:

(3) Scholarships and fellowship grants. For purposes of paragraph (c)(1)(i) of this section, a scholarship or fellowship grant is treated as a qualified scholarship excludable under section 117 except to the extent -

(i) The scholarship or fellowship grant (or any portion thereof) may be applied, by its terms, to expenses other than qualified tuition and related expenses within the meaning of section 117(b)(2) (such as room and board) and the student reports the grant (or the appropriate portion thereof) as income on the student's federal income tax return if the student is required to file a return; or

The "paragraph (c)(1)(i) of this section" mentioned here is the bit that would normally exclude a qualified scholarship from income under 117, as mentioned in the comments, and also not count for the purposes of determining the amount of an education tax credit. The revenue code explicitly includes examples of the application of these rules, and they involve the choice of categorization of scholarships as income.

In summary, it appears that both the Internal Revenue Code and the publications of the IRS allow for the reporting of a scholarship as income if it may be applied to expenses other than tuition, even if it was in fact used for tuition.

See also 26 CFR § 1.25A-5(b)(1) which is relevant to the example above regarding Ms. Allen. It does not directly address your question, but does demonstrate that even if Ms. Allen paid an institution directly, it is treated as a payment through Todd specifically for the purposes of section 25A ("American Opportunity and Lifetime Learning credits").

Answer 2

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.

Additional assumptions:

• 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.

Scenario 1: • 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.

Scenario 2: • 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.