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I am trying to determine whether or not a particular scholarship I received (the Palmetto Fellows Scholarship in South Carolina) may or must (or may not or must not) be considered taxable income.

Based on this information from the IRS, I believe the Palmetto Fellows Scholarship can be considered tax-free.

A scholarship or fellowship is tax free only to the extent:

It does not exceed your expenses;

It is not designated or earmarked for other purposes (such as room and board), and does not require (by its terms) that it cannot be used for qualified education expenses; and

It does not represent payment for teaching, research, or other services required as a condition for receiving the scholarship. (But for exceptions, see Payment for services,later.

However, if I wish to report it as taxable income for the purpose of then claiming the American Opportunity tax credit, is that legal?

I've read several articles online that say you can only count a scholarship as taxable if it is used for educational expenses other than tuition and fees. Truthfully, I only used the scholarship for tuition and fees.

But, according to the Adjustments to Qualified Education Expenses section in this document from the IRS, the regulations don't say anything about what the scholarship is used for but instead what is allowed to be used for.

Generally, any scholarship or fellowship is treated as tax free. However, a scholarship or fellowship is not treated as tax free to the extent the student includes it in gross income (if the student is required to file a tax return for the year the scholarship or fellowship is received) and either of the following is true.

The scholarship or fellowship (or any part of it) must be applied (by its terms) to expenses (such as room and board) other than qualified education expenses as defined in Qualified education expenses in chapter 1, Scholarships, Fellowships, Grants, and Tuition Reductions.

The scholarship or fellowship (or any part of it) may be applied (by its terms) to expenses (such as room and board) other than qualified education expenses as defined in Qualified education expenses in chapter 1, Scholarships, Fellowships, Grants, and Tuition Reductions.

Looking at the 2nd point above, and the below quote from this document on the Palmetto Fellows,

Charges for room and board are to be limited as follows: 1. Room charges shall not exceed the average cost of on-campus residential housing; and 2. Board charges shall not exceed the cost of the least expensive campus meal plan that includes 21 meals per week.

it would appear that since the Palmetto Fellows may be used for room and board, it may also be classified as taxable income.

If that is true, my deduction is that I can claim the scholarship as additional income and claim the amount that I paid my university for tuition and fees as eligible for the American Opportunity Tax Credit.

2

It appears you can elect to classify some or all of your scholarship money as taxable. If you do this, you would be deemed to have used the scholarship funds for non-deductible purposes (e.g., room and board), and you could be eligible to claim the American opportunity credit based on the money you used to pay for the tuition out of your own pocket.

I found this option in the section of Publication 970 about "Coordination with Pell grants and other scholarships", specifically example 3:

The facts are the same as in Example 2—Scholarship excluded from income [i.e., Bill receives a $5600 scholarship and paid $5600 for tuition]. If, unlike Example 2, Bill includes $4,000 of the scholarship in income, he will be deemed to have used that amount to pay for room and board. The remaining $1,600 of the $5,600 scholarship will reduce his qualified education expenses and his adjusted qualified education expenses will be $4,000. Bill's AGI will increase to $34,000, his taxable income will increase to $24,250, and his tax before credits will increase to $3,199. Based on his adjusted qualified education expenses of $4,000, Bill would be able to claim an American opportunity tax credit of $2,500 and his tax after credits would be $699.

You can only reclassify income in this way to the extent that your scholarship allows you to use that money for nonqualified expenses (such as room and board). You should carefully check the terms of the scholarship to determine whether it allows this. The brief paragraph you cite from the Palmetto fellowship document is not totally clear on this point (at least to my eye). You might want to ask the fellowship administrators if there are restrictions on how they money may be used.

In addition, I would be cautious about attempting to do this unless you actually did pay for the nonqualified expenses yourself, so you can treat the money as fungible. If, for instance, your parents paid for your room and board, it's not clear whether you could legitimately claim that you used the scholarship money to pay for that, since you didn't pay for it at all (although in this case your parents could possibly be able to claim the AOC themselves). I mention this because you say in your question that you "only used the scholarship for tuition and fees". I'm not sure how exactly you meant that, but it seems from the example cited above that, in order to claim the scholarship as taxable income, you have to actually have nonqualified expenses which you can say you paid for with the scholarship. (Also, of course, you had to actually receive the money yourself. If the scholarship money was given directly to your school as payment of tuition, then you never had any ability to use it for anything else.)

  • If I legally label the scholarship as taxable income, I don't believe that is double dipping because the scholarship is no longer tax-free educational assistance. Therefore I think the real question is, may I claim the particular scholarship I received as taxable income? This is a bit fuzzy because of the may and must language. Even on Worksheet 1-1 the language for line 7 states This amount is the most you **can** exclude from your gross income (the tax-free part of the scholarship or fellowship) . I believe the word can technically means I do not have to claim it as tax free. – Daniel Feb 12 '15 at 4:23
  • I didn't have enough room to add this to my last comment, but I would be interested in hearing your response. Also, to be clear, I am not ungrateful for the scholarship, I am merely trying to do what's most beneficial for me within the parameters of the law. I didn't even know about the possibility of claiming a scholarship as taxable until an H&R Block tax tip mentioned it. Unfortunately it does not go into detail about the qualifications for taxable scholarship and if qualifying as tax-free requires it to be claimed and used as tax-free. – Daniel Feb 12 '15 at 4:27
  • @Daniel: Interesting! It appears you are correct. I found an example in the IRS publication that seems to describe doing what you suggest. I've edited my answer. However, I would say that the scholarship document you linked to is not totally clear on what the funds may be used for. You should review other documents you may have received and/or contact someone who knows and ask them how the fellowship money may be used. – BrenBarn Feb 12 '15 at 9:29
  • I would say there's one major caveat: if the scholarship went directly to your school, you probably can't claim it this way, unless you also paid an equivalent amount in room and board fees (or if you paid a lesser amount, you might claim that lesser amount). If they paid you and then you paid the school, this seems reasonable. – Joe Feb 12 '15 at 15:07
  • @Joe: That is definitely true. The way the question is phrased I assumed the person had received the money themselves. – BrenBarn Feb 12 '15 at 18:46

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