Amending for Education Credits

Introduction

The focal point in tax preparation of returns with education expenses has traditionally been on the tax-free nature of scholarships and grants. However, when practitioners are preparing returns for students, or parents of students, they should not assume everything balances out if the client didn’t actually make payments to the college. Commonly overlooked by individuals and practitioners alike is the fact that student loans are amounts that the student pays for qualified expense, and they consequently qualify for education credits.

Practitioners should also give education credits a second thought when considering the impact of scholarships and grants received, even if they balance out with expenses. Depending on the type of scholarship, they may need to evaluate the potential benefits of Treas. Reg. 1.25A-5, which enables taxpayers to include some scholarships in income and increase amounts qualifying for education benefits. The regulations include several examples which have been included in Pub 970.

Another common assumption is that scholarships are always tax-free, and that they must be used first to reduce qualified educational expenses with only the remaining expenses available for calculating the education credits. That is not true.

Analyzing the potential of an education credit should become a routine part of preparing returns for individuals with educational expenses. Because current software doesn’t generally guide taxpayers in maximizing potential education credits, practitioners may have to put in a little extra effort to insure that the client gets his reward.

Education Credits Background

Two popular education credits that will still be available for the next few years include the American Opportunity Credit (AOTC or AOC) and the Lifetime Learning Credit (LLC). The AOTC is a credit for up to $2,500 of $4,000 for qualified educational expenses, with 40% of that allowed as a refundable credit. The AOTC is also referred to as the Hope Scholarship, although the original Hope scholarship was limited to the first two years of college. The American Opportunity Tax Credit is the title of IRS Code Section 25A(i) that describes changes to the Hope Scholarship so both reference the same credit. Lower income taxpayers are likely to use the American Opportunity Credit since it does not require taxable income for the refundable part of the credit.

The LLC is a credit of 20% of up to $10,000 of eligible educational expenses. The key differences in the two are that part of the AOTC may be refundable while the LLC is not, and the AOTC is only available for students seeking a degree/certificate while the LLC is available for all education used to acquire or improve job skills. There are some other minor differences between the two as well.

Taxpayers must choose between the LLC and the AOTC however, as they cannot claim both credits for the same student. Also, if either credit is used, the tuition deduction is not allowed for that student. You can, however, claim the AOTC for one student and the LLC for another. There are also phase-outs for both credits.

There is a maze of other educational benefits that are available which may be more advantageous depending on the taxpayer’s income level, tax bracket and other circumstances.

Qualifying Expenses

Both credits apply to qualified education expenses, although there is a slight difference there as well. For the AOTC qualifying expenses include costs of tuition and required fees, as well as required books. The books do not have to be purchased at the institution. Room and board is not qualifying for the AOTC, but it is for some other financial aid, so it may be necessary to coordinate with other allowances to receive the maximum benefit.

Who qualifies?

The AOTC in effect encourages students to wait a few years to begin college or be supported by their parents while attending college. Students under the age of 24 only qualify for the nonrefundable portion of the credit in some cases. Filing a joint return or when both parents are deceased are two cases. Publication 970 provides these qualifications.

You do not qualify for a refund if items 1 (a, b, or c), 2, and 3 below apply to you.
1.    You were:
    a.    Under age 18 at the end of 2013, or
    b.    Age 18 at the end of 2013 and your earned income (defined below) was less than one-half of your support (defined below), or
    c.    Over age 18 and under age 24 at the end of 2013 and a full-time student (defined below) and your earned income (defined below) was less than one-half of your support (defined below).
2.    At least one of your parents was alive at the end of 2013.
3.    You are filing a return as single, head of household, qualifying widow(er), or married filing separately for 2013.

See Section 25A(i)(5) and references for specific details. Students age 24 and over also qualify for the refundable portion of the credit, as well as parents of children under the age of 24 if they claim the child as a dependent. Taxpayers can use the IRS Interactive Tax Assistant at http://www.irs.gov/uac/Am-I-Eligible-to-Claim-an-Education-Credit%3F to see if they qualify. The credit is attached to the dependency, so if the parent claims the AOTC for a child, the child will not be able to claim his own exemption. Recent proposals have suggested that the qualifying age be reduced to 21, so a review of current laws may be appropriate.

What are qualifying payments?

Payments for qualifying expenses include amounts paid by the student, or by the parents for the student, or paid through student loans. Also qualifying are payments made by a third party that are in the nature of a gift. So if the grandparent pays for part of the cost of attending college, the student (or parents) can claim the credit using those amounts.

Scholarships and Grants

The primary purpose of this article relates to how amounts paid by scholarships and grants can be used to qualify for education credits. The definition of different types of scholarships may cause confusion in evaluating possible treatment. Section 117 defines qualified scholarships as any amount of a scholarship used for qualified expenses. However some scholarships can be treated as taxable or non-taxable based on the terms of the scholarship as outlined in Regulation 1.25A-5(c)(3). [1] The regulation also includes multiple examples illustrating the potential effects of considering scholarship taxable income. For tax purposes, grants follow the same logic as scholarships.

Three Types of Scholarships

The code only describes taxable and qualified (or tax-free) scholarships, and qualified scholarships only describe amounts of a scholarship that are used to pay qualified expenses. In order to better understand the types of scholarships in regards to tax treatment, I define scholarships as exclusive, taxable, or elective. Briefly, exclusive scholarships cover only qualified expenses, taxable scholarships cover only non-qualified expenses, and elective scholarships may be used to cover qualified or non-qualified expenses. The elective nature of the third type is what enables us to re-allocate scholarship amounts, increasing qualified expenses to achieve the highest credit amount.

Exclusive Scholarships

Exclusive scholarships are those scholarships, by the terms of scholarship, which must be used to pay qualified expenses. The full amount of the scholarships must reduce the amount of qualified expenses. Because the scholarship must be used for qualified expenses, no amount should be refunded. A refund, however, may not change the terms of the scholarship.

Taxable Scholarships

A scholarship that must be used exclusively for other than qualified expenses is taxable, but not considered earned income. It is reported on line 7 as scholarship income with other taxable scholarships. Room and board is not a qualifying expense, so scholarships that cover only that is normally taxable. Scholarships in excess of qualifying expenses are also treated as taxable scholarships.

As you will see next, some scholarships can be treated as taxable scholarships.

A scholarship that pays students for services they must perform, such as teaching or research, are taxable and reported as earned income on a W-2. They should not enter into the calculation of education credits.

Double requirements

Some scholarships may be required to be used for a combination of qualifying and non-qualifying expenses, for example, tuition and room and board. These scholarships would be part exclusive and part taxable. If that is the case, the amount must be allocated between the two amounts.

Elective Scholarships

The third type of scholarship is the elective scholarship. The term elective is not defined in the code as such but the concept is taken from Regulation 1.25A-5(c)(3) where scholarship amounts can be treated as either taxable or tax-free. The concept is also published in IRS Publication 970. The phrase that separates exclusive from elective in this context is "used for other than qualified expenses."  If a scholarship may or must be used for other than qualified expenses you can elect to include it in income, or treat it as tax-free and offset qualified expenses. When treated as income, the amount of qualified expenses is not reduced and the taxpayer may qualify for a higher education credit.

Scholarships that are available for elective treatment also include Pell grants and most other federal aid, as well as Coverdell Educational Savings Accounts.

All of the circumstances should be weighed when determining if a scholarship, grant, or other source is evaluated for possible treatment as an elective scholarship suitable for maximizing the education credits. However, some key words to look for are "room and board", "living expenses", and "excess refunded". 

Scholarships that are merely based on the “amount of” tuition instead of “used for” tuition may also be considered elective scholarships. Just because a scholarship is based on the costs of tuition does not mean it is limited to tuition costs.

In an IRS ruling related to the Louisiana Tuition Opportunity Program for Students (TOPS) program in Louisiana, it was determined that the TOPS awards could be applied to Section 25A and 117 in determining tax treatment.  In 1999 the Louisiana legislature went from a system that required a TOPS award to be used for tuition to a system that measures the amount of the award by the amount of tuition.

Although the ruling cannot be used as precedent, it is a logical assumption that the recipient could use the funds for other expenses. The TOPS ruling confirms that (then proposed) Reg. § 1.25A-5(c)(3) allows this grant to be considered a "qualified scholarship excludable from income under section 117" unless:

(i) The grant is reported as income on the taxpayer's federal income tax return, or

(ii) The grant must 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.”[2]

On the other hand, the Texas Hazlewood Exemption for Texas veterans would not be considered elective because of its strict regulation that amounts are for tuition and required fees, and because it is an exemption rather than an amount provided to the taxpayer.

As more taxpayers take advantage of Regulation 1.25A-5(c)(3), the IRS may issue other regulations clarifying what constitutes elective scholarships.

Research

Determining if particular scholarships can be elective requires research, but that research outlay can be used on multiple returns. A practitioner that researches area scholarships in advance can answer questions about the elective nature of particular scholarships. A repository of information related to these scholarships will be invaluable during tax season. Finding out if scholarships can be taxable can be a formidable task, however.

I haven't been able to acquire legal documents that spell out the terms of scholarships at local institutions. There are, however, official representations of the terms of several popular scholarships in Tyler institutions’ websites. In most of the UT Tyler scholarships, the first item describing the requirements is "Award may be used for the payment of tuition, fees, books and supplies at UT Tyler only." and then there is an addition that "Any remaining funds will be disbursed on the published financial aid disbursement date."  If you apply logic, it seems to allow you to use remaining funds for personal expenses, and thus it may be used for other than qualified expenses. Fortunately, you don't have to twist any words here. The UT Tyler Scholarship FAQ page confirms:

Q: Will scholarship awards apply to tuition, fees, books, supplies, and housing?

A: Yes, up to the value of the award.

Q: If I have monies left over on my account after everything is paid, will I get those monies?

A: Yes... Remaining funds will be refunded....[3]

I suspect such elective scholarships are more common today because institutions don't want to keep track of whether you use the resources for qualified expenses. Everything is grouped together, tuition and fees are paid, and the excess is refunded. However, it is best to find something that says so.

Federal grants are another common source of financial aid. Most federal aid, including the Pell Grant, are need-based, and since the term "need" includes food and a place to stay, you might conclude that they may be used for other than qualified expenses. Again you don't have to wrangle with that.

Q6. What costs does a Federal Pell Grant cover?

A6. Federal Pell Grants are available if you are taking classes as part of a program that leads to an undergraduate degree or certificate. Federal student aid, including Pell Grants, can be used to cover a variety of costs, generally including

Tuition and fees normally assessed;

Books, supplies, transportation, and miscellaneous personal expenses;

Living expenses such as room and board; and

An allowance for costs expected to be incurred for dependent care for a student with dependents.[4]

The Texas State Board of Public Accountability (TSBPA) Fifth-Year Accounting Student Scholarship was one that I had to be concerned about in claiming the education credit, but again I did find this line on the TSBPA website that describes the uses for the award:

The award may be used at a participating college or university in Texas that is recognized by the Board. The award may be used for tuition, fees, books, supplies, and living expenses incurred by the student in connection with the student's fifth year of an accounting program.[5]

Document

Just as you would document that amounts were paid, or that a scholarship was used for qualified expenses, you should document your ability to treat scholarships as taxable. Keep some official source document that says the scholarship may be used for other than qualified expenses, i.e. room and board. Official letters from the institution or printouts from official web pages would be some examples.

Organizing Expenses and Payment Records

Although Treasury Regulation 1.117-1 says you should exclude scholarships from income to the degree they are used for qualified expenses, Treasury Regulation 1.25A-5(c) explains how you can manipulate some scholarships to increase the amount of qualified expenses you can use in calculating an education credit. The best way to determine the amounts to include in income requires some organization of expense and payment records.

The Value of a 1098-T

Although the IRS requires many institutions to provide students with a 1098-T showing expenses and aid received, and Form 8863 provides areas to enter the amounts, instructions include the admonition to verify the accuracy or 1098-T amounts. That admonition should be heeded because 1098-T amounts may rarely be accurate. In earlier times the 1098-T was more practical when class registration took place in January of the year of attendance and tuition and fees were recorded on a calendar basis. Now most colleges open registration in the last month or two of the previous term. Because expenses are similar from year to year, accuracy is coincidental, and specific circumstances such as first and last term could show drastically different amounts.

The two most commonly reported amounts on a 1098T are in Box 1 and Box 2. Box 1 amounts show amounts paid for qualified expenses. Because this box shows expenses paid by all sources, including scholarships and grants, it is of limited value in showing what you can claim as amounts paid. Box 2 shows amounts billed for qualified expenses and it is less accurate because often institutions bill students in November or December for the spring semester of the following year.

For qualified expenses on record in December, but for the school term beginning in January of the following year, the payments will be qualified in the year paid. Note, however, that amounts paid in a prior year can only be claimed in that prior year, in line with Regulation 1.25A(e)(2), and if the payment is for expenses in the first three months of the following year.

To make things even more confusing, institutions are not required to prepare and submit 1098-Ts under certain conditions. One condition is if all expenses are paid by scholarships and grants. Many students may be missing out on the AOTC for this reason alone. Failure to receive a 1098-T doesn't disqualify you from receiving the AOTC. If that is the case, don't waste time waiting for one to come in the mail.

Spreadsheet for Expense Calculations

While you can spend time verifying and adjusting the amounts on a 1098-T, taking a few minutes to get an account statement from the college will insure the taxpayer has an accurate record of amounts received and spent on qualifying expenses. Account records are usually accessible on-line by the student or parent claiming the education credit, but expense amounts should be calculated on a term basis.

The creation of a spreadsheet to calculate the amounts can be greatly simplified with the information provided on-line. If the account information cannot be exported into a file you can download, you may be able to mark, copy, and paste the amount from a web page and into a spreadsheet.

Account Record

Date

Item

Term

Charge

Payment

Refund

12/9/2011

BIOL Course Fee -  ANATOMY/PHYSIOLOG...

2012 Spring

61

   

12/9/2011

COSC Course Fee -  INTERNET & WEB APPL..

2012 Spring

108

   

12/9/2011

Designated Tuition - Undergrad

2012 Spring

2,476

   

12/9/2011

Lab Fee -  ANATOMY/PHYSIOLOGY LAB II

2012 Spring

5

   

12/9/2011

Mandatory Fees - Fall/Spring

2012 Spring

915

   

12/9/2011

Resident Tuition

2012 Spring

600

   

12/9/2011

Student Services Fee

2012 Spring

132

   

12/9/2012

Parking Permit Fall

2012 Spring

30

   

12/21/2011

MANA Course Fee -  DATABASE INFO SYST…

2012 Spring

49

   

1/6/2012

Direct Stafford Loan

2012 Spring

 

2,737

 

1/6/2012

Federal Pell Grant

2012 Spring

 

2,775

 

1/6/2012

M J Harvey Sr Memorial End

2012 Spring

 

1,000

 

1/6/2012

Texas Public Ed. Grant

2012 Spring

 

1,000

 

1/9/2012

Refund - Other

2012 Spring

   

2,737

1/20/2012

Refund - Other

2012 Spring

   

399

 

There will usually be two or three columns, Charges, Payments, and possibly Refunds. Once the raw data is pasted into a spreadsheet, rename the existing columns to Qualified Expenses, Elective Scholarships, and Loans/Other. Between the first two amount columns, insert columns for Non-Qualified Expenses (the parking permit isn't qualified) and Qualified Scholarships. Add separate columns for Taxable Scholarships if applicable. Then move amounts to their appropriate column. Irrelevant amounts such as refunds can be grouped with student loans. You may only need to move a few amounts as most will probably be qualifying expenses. When complete, add totals to the columns and use those amounts in the following worksheet to maximize education credits. Depending on the education credit you are claiming, be sure to add other qualifying expenses, such as required books and other course materials. This should be done even if you have $4,000 in educational expenses since they make that amount of remaining scholarships tax-free. If they are not purchased at the institution, you will have to add them manually.

Expense Spreadsheet

Date

Item

Term

Qual
Exp

Non Qual
Exp

Non Taxable
Schps

Elective
Schps

Loans/
Other

12/9/2011

BIOL Course Fee - ANATOMY/PHYS…

2012 Spring

61

       

12/9/2011

COSC Course Fee - INTERNET & WEB..

2012 Spring

108

       

12/9/2011

Designated Tuition - Undergrad

2012 Spring

2,476

       

12/9/2011

Lab Fee - ANATOMY/PHYSIOLOGY L…

2012 Spring

5

       

12/9/2011

Mandatory Fees - Fall/Spring

2012 Spring

915

       

12/9/2011

Resident Tuition

2012 Spring

600

       

12/9/2011

Student Services Fee

2012 Spring

132

       

12/9/2012

Parking Permit Fall

2012 Spring

 

30

     

12/21/2012

MANA Course Fee - DATABASE INFO..

2012 Spring

49

       

1/6/2012

Direct Stafford Loan

2012 Spring

       

2,737

1/6/2012

Federal Pell Grant

2012 Spring

     

2,775

 

1/6/2012

M J Harvey Sr Memorial End

2012 Spring

     

1,000

 

1/6/2012

Texas Public Ed. Grant

2012 Spring

   

1,000

   

1/9/2012

Refund - Other

2012 Spring

       

2,737

1/20/2012

Refund - Other

2012 Spring

       

399

     

4,346

30

1,000

3,775

5,873

Worksheet to maximize education credits

The IRS does have a worksheet for calculating the education credit included in Pub 970 and other sources, but it is used to calculate what can be excluded from income and lacks the logic included in the regulations for elective taxable scholarships. The following worksheet can be used to aid in calculating the maximum AOTC amount. It can also be expanded or condensed to suit the needs of the practitioner. Excel Formulas are given in the final column appropriate for the listed columns.

This worksheet assumes the taxpayer does not have any outstanding balances, and does not consider other educational assistance, or the possibility of excluding qualified expenses of other types of financial aid. With more complex arrangements, additional research and manipulation may be necessary.

A

B

C

D

Formulas

1


Qualified Expenses

Enter the total amount of your qualified education expenses.

4,346

 

2

Total Scholarships

Enter the total amount of all scholarships and grants received for the tax year.

4,775

 

3

Taxable Scholarships

Enter the amount of scholarships required to be used for other than qualified expenses.

-0-

 

4

 

Subtract line 3 from line 2.

4,775

=D2-D3

5

Excess Scholarships

If line 4 is greater than line 1, subtract line 1 from line 4.

429

=IF(D4>D1,D4-D1,0)

6

Potential Tax-free Scholarships

Subtract line 5 from line 4.

4,346

=D4-D5

7

Exclusive scholarships

Enter the amount of the scholarships that you are required to use for qualified educational expenses.

1,000

 

8

Elective Scholarships

If line 6 is greater than line 7, subtract line 7 from line 6.

3,346

=IF(D6>D7,D6-D7,0)

9

Excess Expenses Paid by Taxpayer

If line 1 is greater than line 6, subtract line 6 from line 1. Otherwise, enter 0.

-0-

=IF(D1>D6,D1-D6,0)

10

Qualified Expenses for
Tax Credit

Add line 8 and line 9 (maximum 4000). Enter this amount on line 27 of Form 8863.

3,346

=MIN(4000,D9+D8)

11

Elective Scholarships Includable in Income

If line 9 is less than line 10, Subtract line 9 from line 10. Otherwise, enter 0.

3,346

=IF(D9<D10,D10-D9,0)

12

Taxable Scholarships Included
in Income

Add line 3, line 5 and line 11. This is the amount of taxable scholarships. Enter SCH and this amount on the dotted line to the left of line 7. Include this amount in the total on line 7 of Form 1040.

3,775

=D3+D5-D11

 

Note that scholarship amounts that cover services rendered such as teaching or research are normally considered taxable earned income, not scholarship income, and would not enter into the calculations.

Following are scenarios illustrated in examples from Publication 970 and Regulation Section 1.25A-5.

970-1: Bill Pass, age 28 and unmarried, enrolled full-time in 2013 as a first-year student at a local college to earn a degree in law enforcement. This was his first year of postsecondary education. During 2013, he paid $5,600 for his qualified education expenses and $4,400 for his room and board for the fall 2013 semester. He and the college meet all the requirements for the American opportunity credit. He figures his American opportunity credit based on qualified education expenses of $4,000, which results in a credit of $2,500.

970-3: The facts are the same as in 970-1, except that Bill was awarded a $5,600 scholarship. Under the terms of his scholarship, it may be used to pay any educational expenses, including room and board. If 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. Based on his adjusted qualified education expenses of $4,000, Bill would be able to claim an American opportunity tax credit of $2,500.

25A-2: University X charges Student A, who lives on University X's campus, $3,000 for tuition and $5,000 for room and board. University X awards Student A a $2,000 scholarship. The terms of the scholarship permit it to be used to pay any of a student's costs of attendance at University X, including tuition, room and board, and other incidental expenses. University X applies the $2,000 scholarship against Student A's $8,000 total bill, and Student A pays the $6,000 balance of her bill from University X with a combination of savings and amounts she earns.

Student A reports the entire scholarship as income on the student's federal income tax return. Therefore, for purposes of calculating an education tax credit, Student A is treated as having paid $3,000 of qualified tuition and related expenses to University X.

25A-4: The facts are the same as in 25A-2, except that the terms of the scholarship require it to be used to pay tuition or room and board charged by University X, and the scholarship amount is $6,000. Student A may allocate the scholarship between tuition and room and board in any manner. However, because room and board totals $5,000, that is the maximum amount that can be applied under the terms of the scholarship to expenses other than qualified expenses and at least $1,000 of the scholarship must be applied to tuition. If Student A reports $5,000 of the scholarship as income on the student's federal income tax return, then Student A will be treated as having paid $2,000 ($3,000 tuition−$1,000 qualified scholarship excludable under section 117) in qualified tuition and related expenses to University X.

     

970-1

970-3

25A-2

25A-4

1

Qualified Expenses

Enter the total amount of your qualified educational expenses.

5600

5600

3000

3000

2

Total Scholarships

Enter the total amount of all scholarships and grants received for 2013.

0

5600

2000

6000

3

Taxable Scholarships

Enter the amount of scholarships required to be used for other than qualified expenses.

 

 

 

5000

4

 

Subtract line 3 from line 2.

0

5600

2000

1000

5

Excess Scholarships

If line 4 is greater than line 1, subtract line 1 from line 4.

0

0

0

0

6

Potential Tax-free Scholarships

Subtract line 5 from line 4

0

5600

2000

1000

7

Exclusive Scholarships

Enter the amount of the scholarships that you are required to use for qualified educational expenses.

 

 

 

1000

8

Elective Scholarships

If line 6 is greater than line 7, Subtract line 7 from line 6.

0

5600

2000

0

9

Excess Expenses Paid by Taxpayer

If line 1 is greater than line 6, Subtract line 6 from line 1

5600

0

1000

2000

10

Qualified Expenses for Tax Credit

Add line 8 and line 9 (maximum 4000). Enter this amount on line 27 of Form 8863.

4000

4000

3000

2000

11

Elective Scholarships Includable in Income

If line 9 is less than line 10, subtract line 9 from line 10. Otherwise, enter 0.

0

4000

2000

0

12

Total Scholarships Included in Income

Add line 3, line 5 and line 11. This is the amount of taxable scholarship. Enter SCH and this amount on the dotted line to the left of line 7. Include this amount in the total on line 7 of Form 1040.

0

4000

2000

5000

Planning

Typically, school years span five taxable years, with the student only going to school one semester in each of the first and last years, but the credit can only be claimed for four years. If the student has limited expenses in some semesters she may wish to wait until years where qualifying expenses are greater, or a final semester when she has taxable income where she can take advantage of the nonrefundable portion of the AOTC.

Another method to accelerate qualifying expenses is to make allowable prepayments. To maximize the potential benefits it may be possible due to Regulation 1.25A-5(e)(2)  to pay for  the final semester in the prior year. Prepayments must apply to expenses incurred in the first three months of the subsequent year.

It is also possible that the AOTC can be used to pay for the first two semester of graduate school. If a student graduates in May and then attends graduate school through the end of the year (summer and fall), all expenses for the year qualify for the AOTC. Form 8863 instructions are correct in indicating that the student cannot have earned a degree before the start of the tax year. Comments added to the final Treas. Reg. 1.25A-3(d)(2) in TD 9034 clarify that qualified expenses paid during the entire taxable year may be included in calculating the credit even if the student had completed their (then) first two years of undergraduate study during the year. Understanding the benefits to graduate students can be important since other benefits, such as the Pell grant, go away at the same time tuition costs increase.

With the current law scheduled to expire in 2018, and no surety that it will be extended, few years remain to allow for planning how and when to use the AOTC.

Coordinating with other educational assistance

Just as important as understanding the elective nature of traditional scholarships, federal grants, and AOTC qualified expenses, practitioners should be aware of other forms of financial aid and how they potentially interact with educational costs such as room and board or computer technology. Whenever possible, practitioners should look for the best combination of benefits, and work to coordinate them.

Some candidates for coordination include Section 529 QTPs, Coverdell ESAs, and traditional or Roth IRAs.

Section 529 & Coverdell

In both Section 529 plans and Coverdell accounts contributions are not deductible but distributions are tax free if used for qualifying educational expenses. Section 529 QTP plans and Coverdell ESAs can be included in the calculation of elective scholarships. This is partly due to the terms in Section 529(e)(3)(B)(i) that allow room and board expenses for students attending at least half-time. Thus, even though housing costs paid from a Coverdell can be tax-free; those amounts do not offset qualified expenses includable for the purpose of education credits. Publication 970 also confirms this by describing how to coordinate with other aid to maximize education credits.

The inclusion of an amount from these plans in income may be subject to a 10% penalty. Distributions, however, are not subject to a penalty provided the student receives a qualified scholarship that is used for qualifying expenses. That would then expose only the earnings to inclusion in taxable income, much like elective scholarships; and taxability of earnings is essentially limited to a pro rata share of earnings. Keep in mind that a qualified scholarship is that portion of a scholarship used to pay qualified education expenses. Electing to include all scholarships in income would mean there is no qualified scholarship and the penalty may apply.

A primary strategy then would be to use amounts from tax-free aid (Section 529, Coverdell, etc.) to cover room and board, which qualify as tax-free under those code sections; and if needed, use other scholarships as income to increase qualified expenses for the purposes of the education credits.

Computers

Yet another bonus of Section 529  is that certain computer technology purchases are now added to the list of college expenses that can be paid for by a qualified tuition program.  The definition of qualified expenses in Section 529(e)(3)(A)(iii) includes computer technology, equipment and Internet access if they are used by the beneficiary and family. Computer equipment is only qualified for purposes of the AOTC if it is required.  

Q7. Does an expenditure for a computer qualify for the American opportunity tax credit?

A. Whether an expenditure for a computer qualifies for the credit depends on the facts. An expenditure for a computer would qualify for the credit if the computer is needed as a condition of enrollment or attendance at the educational institution.[6]

One characteristic of the Coverdell ESA is that there is a $2,000 annual contribution limit, but distributions can also be used for elementary and secondary education expenses. Also, contributions to an account cannot be made after the beneficiary is age 18, and amounts must be distributed by the time the beneficiary is age 30. It is possible, though, to convert the trust to a new account or beneficiary.

IRAs

Traditional and Roth IRAs are treated similar to Section 529 and Coverdell savings accounts in relation to taxability of earnings and penalties if distributed and used for non-qualified educational expenses. However these IRAs have the added benefit of qualifying for the current Retirement Savings Credit when contributions are made, and do not require distributions when the beneficiary is a certain age. Like the Coverdell, qualified expenses for the IRA include room and board for students that are at least half-time.

Side Effects and Concerns

The reporting for Education Credits could affect a number of other areas, so a careful eye is essential. These are just a few possible side effects or concerns.

AGI: By including scholarships in income, AGI increases and tax may be owed on the scholarship amounts. The first $2,000 of expenses generate a 100% tax credit, but the second $2,000 only generate a 25% tax credit. If the marginal tax rate is above 25%, then it may be better to only include $2,000 of elective scholarships in income. The increase in AGI could initiate phase-outs or subject the taxpayer to AMT.

 

Earned Income: Scholarship income is excluded from earned income in the calculation of the earned income credit, so be sure to report and treat it that way. Include SCH and the amount to the left of line 7 on 1040. If you forget to add the SCH note, the IRS may "correct" the return and send the taxpayer an additional earned income credit which he doesn't deserve and may have to repay. Only amounts you receive for teaching, research, or other services would be considered earned income. Those amounts are not tax-free scholarships although they can be used to pay education expenses qualifying for education credits.

Although scholarships are not earned income, increases to AGI could lower the EITC since the credit is the lower credit based on earned income or AGI.

Support: Scholarships as support should not be a concern with current laws. If scholarships are used for qualified education expenses, they will not be considered support in determining dependency. If the student includes scholarships in income to maximize and it is considered support, it would be irrelevant since the education credit attaches to the exemption.

Educational Assistance: The amount that can be used to qualify for the AOTC education credit that are from an educational assistance program will depend on whether it is an educational assistance program under section 127(b). Additional research may be necessary.

1098-T: Although the 1098-T may not be accurate, the IRS may look at their 1098-T records to determine if a student was attending a college or university. Colleges and universities are not required to submit or provide a 1098-T to their students in some cases. If one is not on file, you could receive a Form 886-H-AOC requesting alternate proof of attendance.

Education Credit Fraud

The benefits associated with education credits has recently been a target for tax fraud. At one point the IRS was examining returns with education credits more closely. However, the fraud has reportedly not been related to options made available in Regulation 1.25A-5. Instead, the cases that made their way to Tax Court had more to do with the plain language of basic qualifications such as age requirements, dependency exemptions, actual expenses[7], prepayments[8], and phase-outs.

In 2013, many of the problems associated with education credits were due to forms not being completed properly, either through preparer negligence or software error.

The only case I found that concerned Treas. Reg. 1.25A-5 was a discussion of the change in a Louisiana program (TOPS) previously mentioned. The fact that there are so few cases that deal with the elective nature of scholarship income suggests that these regulations may be underutilized.

The reallocation of Pell grants to income to maximize the tax credit was most recently summarized in a Fact Sheet[9] distributed by the Treasury Department.

Amending Prior Year Returns

When practitioners see clients they often like to see the prior year's return(s). That helps them to know what kind of credits and deductions you have taken in the past. A bright preparer will also reverse that logic. If he discovers that the taxpayer has credits or deductions this year that were not reported on the prior year's return he can question the taxpayer about whether he qualified for credits and deductions for the prior year, and then amend those returns. At that time, they may want to review the other two prior returns as well.

Many taxpayers may be left in the dark because institutions are not required to prepare 1098-Ts when all expenses are paid for by scholarships and grants. Practitioners should question any taxpayer in school, or with children in school about the nature of their educational expenses.

If taking advantage of Regulation 1.25A-5 in maximizing education credits is a new revelation, amending prior year returns can multiply the benefit by a factor of four and potentially earn $10,000 in education credits. When filing a return in the spring semester of the student’s senior year a taxpayer (student or parent) can amend returns for his freshman, sophomore, and junior year at the same time he files his senior year return. As previously mentioned, there may be years that are more beneficial than others, so planning is still a factor.

Conclusion

When clients mention educational expenses and then dismiss them because everything was covered by scholarships and other financial aid, ask to take a look and explain that they may be able to claim education credits of up to $2,500, especially if some of the expenses were paid with student loans. By understanding the regulations and the ability to treat scholarships as income, you can pleasantly surprise your clients. All that is needed is a little pre-season preparation, organization of client educational records, and a worksheet that calculates qualifying expenses used for the credit. Then see if that can be duplicated with prior year returns.

Comments

This article was written by Dana Bell, EA, of Tyler, Texas. It is posted on the blog, Switched Keys. The AOTC Worksheet is also available as a separate PDF download. Comments, questions, and corrections are welcome and can be submitted through the contact form.


[1] http://www.law.cornell.edu/cfr/text/26/1.25A-5. Accessed 11/6/2014.

[2] PLR 200137006.

[7] Adams v Comm’r, Tax Court Summary Opinion 2013-57.

[8] Jayesh B. v Comm’r, Tax Court Summary Opinion 2006-40.

[9] http://www.treasury.gov/connect/blog/Documents/Pell%20AOTC%204%20pager.pdf. Accessed 11/6/2014.

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