Tax Connections Newsletter – Summer 2022
Robert Swenson

Are Scholarships Taxable?

For parents faced with the soaring cost of higher education, a scholarship can provide welcome financial relief. Most parents assume that scholarships are tax-free, but that is not always the case.

Scholarships 101

Scholarships received by degree candidates are tax-free to the extent that they are used to pay for qualified tuition and related expenses. These expenses include:

  • Tuition and fees required to attend the school; and
  • Fees, books, supplies and equipment required for courses at the school.

This tax break is not available for other school-related expenses, such as room and board, travel and research, subject to the exceptions below. Also, scholarships may not be tax-free to the extent that they represent payment for teaching, research or other services required as a condition for receiving the award.

Exceptions to the room and board rule

What about scholarships tied to the recipient’s participation in certain activities, such as athletic or music performance scholarships? Generally, these scholarships are tax-free, provided the student is expected, but not required, to participate in a particular sport or music ensemble. In other words, to avoid taxation, the scholarship must continue even if the recipient is injured or simply chooses not to participate.

Exceptions to the payment-for-services rule

Certain scholarships are tax-free even though they are tied to the performance of services. Examples include awards received under:

  • The National Health Service Corps Scholarship Program;
  • The Armed Forces Health Professions Scholarship and Financial Assistance Program; or
  • A comprehensive student work-learning-service program operated by one of a handful of federally-recognized “work colleges.”

There is also an exception for qualified tuition reductions received by employees of an educational organization. Graduate students who receive tuition reductions or waivers in exchange for teaching or research activities need not report these benefits as income. Similarly, tuition reductions enjoyed by an educational organization’s employees or their family members are tax-free, provided the program does not discriminate in favor of highly-compensated employees.

Reporting and kiddie tax rules

If a scholarship is partially taxable, the student should report this income on Form 1040. Income that constitutes payment for services is considered earned income and will be included on the student’s Form W-2. Form 1098-T, prepared by the educational organization, will show scholarships received and amounts paid for qualified tuition and related expenses. However, you should review this information carefully because some qualified expenses, such as books and equipment, may not be included.

A scholarship is taxable to the extent that money that is not payment-for-services exceeds qualified tuition and related expenses. For example, scholarship funds used for room and board are taxable.

The taxable amount is also considered unearned income for purposes of the “kiddie tax.” So, depending on the recipient’s other income sources, a portion of this income may be taxed at the parent’s marginal rate. Your ORBA tax advisor can help determine whether the kiddie tax applies to your child.

Related Read: What Was Old Is New Again With the “Kiddie Tax”

No surprises

Scholarships can do wonders to offset the high cost of a college education. To avoid tax surprises be sure to familiarize yourself with the tax treatment of these awards.

Tax Tips

How closely held business owners can defer estate taxes

Depending on the size of your closely held business, estate taxes can be a significant burden when you pass ownership from one generation to the next. Fortunately, the tax code provides some relief, allowing eligible estates to defer the payment of certain estate taxes for up to 14 years. To qualify, several conditions must be met:

  • The deceased must have been a U.S. citizen or resident at the time of his or her death;
  • The deceased’s business must have been closely held — that is, it was either: 1) A sole proprietorship; or 2) An interest in a partnership, limited liability company or corporation that meets certain ownership requirements;
  • The business must be engaged in an active trade or business (as opposed to holding passive investments); and
  • The value of the deceased’s interest in the business must be more than 35% of his or her adjusted gross estate.

If your estate qualifies, the executor may elect to defer the portion of estate tax that is attributable to the closely held business interest for up to 14 years. The estate pays interest only for four years and then pays ten annual installments of principal and interest.

Alternative IRA investments: Handle with care

Most people use their IRAs to hold stocks, bonds and mutual funds. But some people opt to place their IRA funds in alternative investments — such as real estate, closely held business interests, precious metals or cryptocurrencies — in an effort to boost their returns. To do so, your IRA custodian must permit such investments, or you must open a “self-directed” IRA.

Alternative investments can be risky, so consult your ORBA tax advisor to avoid potential tax traps. For example, if the IRS concludes that an IRA investment involves self-dealing or prohibited transactions with related persons or entities, you may immediately be subject to taxes and penalties on your entire account balance.

In a recent case, the Tax Court held that a couple was not permitted to invest IRA assets in gold and silver coins stored in a safe in their home. Because they had complete, unfettered control over the coins and were free to use them in any way they chose, the value of the coins was treated as a taxable distribution.

Increased annual gift tax exclusion for 2022

For the first time in several years, the IRS has raised the annual gift tax exclusion, from $15,000 to $16,000 per recipient, effective January 1, 2022. If you regularly make annual exclusion gifts to children or grandchildren or contribute to trusts or college savings plans for their benefit, consider increasing the amounts of those gifts.

For more information, contact Rob Swenson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Tax Services.

Forward Thinking