Student Scholarships – Free Money or Taxable Income?

The taxability of student scholarship funds has been an issue for many years. In any student scholarship, it is important to understand the intention of the funds and the student requirements to maintain the funds. These distinctions will help determine if the funds are considered taxable or nontaxable income.

Let’s take a look at what the Tax Code says: The Internal Revenue Code (Code) Section 117 allows “qualified scholarships” to be excluded from taxable income. Parents may be asking: What is a qualified scholarship? Does my child qualify? Is my child’s athletic scholarship taxable income?

According to Code Section 117, there are a few requirements for the scholarship funds to be nontaxable income, which include:

1. The student must be pursuing a degree at an educational institution.
2. The funds must be used for tuition and related expenses such as fees, books, supplies and equipment required for courses.
3. The funds also cannot be used towards room and board, travel, research and clerical help.
4. The funds must not represent payment for teaching, research or other services provided by the student as a condition for receiving the scholarship.

The scholarship funds used towards room and board, travel, research and clerical help will be considered taxable income. It is also important to remember that if an item is recommended for a course, but not required, then any portion of the scholarship used towards the recommended item will be considered taxable. For example, if a computer tablet is recommended, but not required, any scholarship funds used towards its purchase are considered taxable income. However, if a graphing calculator is required for a class, this item may be purchased with nontaxable scholarship funds.

Let’s say that a student receives a $20,000 scholarship for tuition, and the student chooses to use $500 to buy the latest tablet device for class that was recommended, but not required. Then, the qualified $19,500 would be excluded from gross income and considered nontaxable. The $500 would be included in other income and taxed at normal income tax rates.

Another example could include a $60,000 scholarship for a private university where the student is required to live on campus in the dorms during that year. However, the tuition fees are only $20,000 per year and books, supplies and required equipment only totaled $1,500 during that year. This would mean that $21,500 would be excluded from gross income and considered nontaxable income. The remaining $38,500 would be included in gross income and taxed at normal income tax rates.

Additionally, any scholarship funds that are considered conditional or compensation for any services rendered will be considered taxable income. For example, if a graduate student is required to teach in order to receive $20,000 in scholarship funds, an amount that is ordinarily paid for similar services may be excluded from the nontaxable scholarship amount and taxed at normal income tax rates. Examining this closer, assume the graduate student is required to work 20 hours per week in a research lab, for 39 weeks out of the year. This could constitute $7,020 taxable income at a minimum wage rate of $9 per hour. Therefore, $7,020 of the scholarship would be considered taxable income and $12,980 would be considered nontaxable income.

Many scholarships will advise the participants of the amount of their stipend that exceeds their qualified tuition and related expenses. However, it is the taxpayer that bears the burden of proving that the funds were qualified to be excluded from gross income, so always keep receipts and statements concerning the scholarship and expenses. It is also important to remember that the funds must represent consideration for services rendered or must be a condition of the scholarship funds to be taxable.

In 2004, the graduate students of Brown University1 petitioned the National Labor Relations Board (NLRB) for the right to form a union in order to gain collective bargaining rights. The NLRB rejected their petition, ordering that the graduate student employees at private universities are not employees protected by the National Labor Act and have no right to form unions. The majority’s reasons included the claim that collective bargaining is incompatible with the nature and mission of the university, and the relationship between the graduate students and the university is primarily educational and not economic.

In addition, it was brought to light that all graduate students of Brown University received the same or very similar scholarship amounts regardless of whether they were a teacher’s assistant, research assistant or a fellow (non-working graduate student). In this particular case, the entire scholarship would be nontaxable because the award amount was irrelevant of whether or not the student was teaching, researching or not working. This brings us to the most recent petition brought before the NLRB concerning athletic scholarships.

On March 26, 2014 the NLRB ruled that the football players who received paid scholarships at Northwestern University2 shall be treated as employees for labor law purposes in order that they may form a labor organization to establish collective bargaining power. The NLRB felt that the relationship between the compensated football players and Northwestern University was in fact an economic relationship as the school brought in over $30 million in revenues for the 2012 – 2013 academic year alone.

What does this mean for the taxability of athletic scholarships going forward? In in a letter dated June 27, 2014, the IRS Commissioner, John Koskinen, confirmed that “whether an individual is treated as an employee for labor law purposes is not controlling of whether the individual is an employee for federal tax purposes. Accordingly, the NLRB decision does not control the tax treatment of athletic scholarships. The treatment of scholarships for federal income tax purposes is governed by the Internal Revenue Code.”

The United States Tax Court holds firm that no services provided by the student may be a condition of receiving the qualified scholarship. They further stipulate in James B. Heidel, 56 T.C. 95 (1971) that “students who receive athletic scholarships do so because of their special abilities in a particular sport and are expected to participate in the sport, the scholarship is not cancelled in the event the student cannot participate, and the student is not required to engage in any other activities in lieu of participating in the sport.”

This brings up an excellent distinction between “expected” to participate in the sport verses “required” to participate. If a student is expected to participate in a sport in conjunction with their scholarship, but the scholarship is not canceled in the event the student cannot participate, this constitutes a qualified scholarship and the scholarship is not taxable. It is important to note that if a student voluntarily withdraws from the sport at any time, for any reason, and the scholarship can be reduced or canceled, then that particular scholarship is conditional of the services performed and is considered taxable income. For example, if a student receives a $20,000 athletic scholarship, and upon withdrawal from the sport, the scholarship is reduced to $5,000, then $15,000 of that initial scholarship is taxable income and only $5,000 is nontaxable income. If the entire scholarship is canceled if the student no longer participates in the sport, then the entire scholarship is taxable to the student.

The good news is, not all taxable scholarships specifically mean tax liability. Taxable scholarships should increase the student’s standard deduction. For example, if $5,000 of the scholarship is taxable because it is used towards room and board, and this is the student’s only income, then the student’s earned income would be $5,000 and their standard deduction would be $5,350, bringing their taxable income to zero. Unfortunately, this deduction is capped at the regular standard deduction for single tax payers ($6,200 in 2014).

If you have any questions about a specific scholarship or would like to plan ahead for your child’s tuition, please contact your BPW advisor at (805) 963-7811.

National Labor Relations Board Cases:
¹Brown University, 342 NLRB 483 (2004)
²Northwestern University v. College Athletes Players Association (CAPA), 13-RC-121359 (2014)