By Daniel A. Edelstein, Esq.
Introduction
Though economists may argue the worst of the recession has passed, jobs are still not as plentiful as they were five years ago. Many young adults with carefully-laid career plans, whether based on their own aspirations or the desires of their parents looking forward to retirement, are having trouble finding traditional jobs. Instead, some have returned to school, or assumed temporary or contract positions in order to gain experience and develop contacts. But this has left many with uncertainty as to the tax consequences of such endeavors, which can be especially frustrating when faced with more pressing concerns such as paying rent. This article is based on the state of the law as of May 26, 2011, focusing on the 2010 tax year, and will address some of the most common tax issues surrounding education.
Income Taxation
The first consideration for students, before addressing their income tax liability, is to determine whether a tax return even needs to be filed. If a young adult is single, and has gross income (meaning, generally, all income, in whatever form, and not otherwise exempt from tax) of $9,350 or more, the student must file his or her own return. Internal Revenue Service (hereinafter referred to as, "IRS") Form No. 1040, Instructions (2010). If he or she can be claimed as a dependent on another's tax return, the student must still file his or her own return under three circumstances: (1) the student has more than $950 of unearned income (including taxable interest, ordinary dividends and unemployment compensation); (2) the student has more than $5,700 in earned income (including wages, tips, and taxable scholarship and fellowship grants (see Prop. Treas. Reg. § 1.117-6(h)); or, (3) the total of the student's unearned and earned income is more than $950, or, if larger, the sum of $300 and the student's earned income (up to $5,400). Even if the student has insufficient income to be required to file a return, he or she may still want to in order to receive the refundable portion of the American Opportunity Credit (see infra), or if the student had any withholding on income he or she received (in order to receive a refund). In addition, the student may still have to file, despite his or her low income, if, for example, the student received wages from an employer on which social security and Medicare taxes should have been withheld. IRS Form No. 1040, Instructions (2010).
The distinction between earned and unearned income plays a role in determining whether a student must file a tax return. Another distinction, taxable versus nontaxable income, becomes prominent when considering whether educational assistance will create any tax liability. The section of the Internal Revenue Code (located in Title 26 of the United States Code, and hereinafter referred to as, "I.R.C.," followed by the section number) concerning gross income is one of inclusion, meaning all receipts and benefits accruing to an individual are subject to income tax unless exempted by another provision of the law. See I.R.C. § 61.
There is such a provision that applies to scholarships and fellowships, exempting certain types from tax. Thus, degree candidates at any educational institution ". . . which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on" (I.R.C. § 170(b)(1)(A)(ii)), can receive tax-free "qualified scholarships." Id. § 117(a). The degree being sought can be either undergraduate or graduate, and can be pursued at a primary or secondary school, or even at another institution that offers education or training (if such can be used for credit toward a degree or training for a particular occupation, and in either case only so long as the institution has received government authorization and national accreditation). Prop. Treas. Reg. § 1.117-6(c)(4). Qualified scholarships means scholarships or fellowship grants if used for "qualified tuition and related expenses," in accordance with their terms. I.R.C. § 117(b)(1). Qualified tuition and related expenses, in turn, means tuition, fees, supplies, books & equipment (id. § 117(b)(2)), if required for all students. Prop. Treas. Reg. § 1.117-6(c)(2). The terms of the qualified scholarship need not limit its use to such expenses, but any amounts that cannot be used in this way, or are designated for other purposes, are not qualified and are therefore taxable. Id. § 1.117-6(c)(1).
Qualified scholarships are characterized by their use being to aid students in pursuing studies or research, whether through the payment of money, the contribution of services or accommodations, or tuition reductions. But qualified scholarships do not include aid provided because of philanthropic or family considerations, essentially indicating that the tax treatment of gifts is to be governed by other provisions in the I.R.C. (see infra). Prop. Treas. Reg. § 1.117-6(c)(3)(i); see also id. § 1.117-6(b)(1). Employees at the types of educational institutions described above, as well as their spouses and dependent children, can also receive tax-free "qualified tuition reductions" for undergraduate or graduate education at such institutions (subject to certain requirements relating to non-discrimination between highly-compensated and other employees, which are beyond the scope of this article). I.R.C. §§ 117(d)(1), (2), (4), 132(h). It should be noted, though, that both qualified scholarships and qualified tuition reductions mustbe used within the United States to be tax free. IRS Pub. No. 970 (2010).
Another restriction on qualified scholarships and tuition reductions is that, even if services are a required part of a degree program, any of these forms of educational assistance that constitute payment for such services are taxable. IRS Pub. No. 970 (2010); Prop. Treas. Reg. § 1.117-6(d)(1). Thus, with a few exceptions for specific federal programs, the exclusion in I.R.C. § 117(a) does not apply to payments received by a student if in compensation for research, teaching or other services he performed as a condition to receiving the qualified tuition reduction or qualified scholarship. Id. § 117(c)(1). Thus, whether such services were required to receive the degree is irrelevant. Prop. Treas. Reg. § 1.117-6(d)(1).
The determination that payment is being offered for services is based on the qualified scholarship only being offered as a quid pro quo for the performance of services (whether in the past, present or future), or on the requirement that the student conduct research, studies or other activities which are of primary benefit to the grantor of the qualified scholarship. Prop. Treas. Reg. § 1.117-6(d)(2). In the words of the United States Supreme Court, "the ordinary understanding of 'scholarships' and 'fellowships' [is that of] relatively disinterested, 'no-strings' educational grants, with no requirement of any substantial quid pro quo from the recipients." Bingler v. Johnson, et al., 394 U.S. 741, 751 (1969). A factual analysis is used to differentiate between payments having a primary purpose of education and training, and those having a primary purpose of compensating for past, current or future services (future meaning that the person is obligated to work there after completion of the scholarship or fellowship). Important facts include the nature of the relationship between the student and the grantor, the type of work being done, the involvement with the school or other program, the character of the payment and any corresponding benefits, and whether the payments are based on the value of the services instead of the financial need of the student. See id. at 757-58; Swart v Comm'r., T.C. Memo 1978-38. If only part of the scholarship or fellowship is payment for services, the amount of such is determined by comparison to the compensation, for similar services, that is paid to others who do not receive the assistance (whether they be students, or employees of the same or a different organization). Prop. Treas. Reg. § 1.117-6(d)(3). If the amount considered taxable is "reasonable compensation" for the services provided, the balance of the scholarship (whether it be money or a tuition reduction) is tax-free, so long as it is used for qualified tuition and related expenses. Id. § 1.117-6(d)(3), (5), Examples (5), (6).
But if part or all of a scholarship or fellowship is taxable, neither the law nor guidance from the IRS is clear as to the reporting method. The options available are to include the income with other wages (IRS Form No. 1040, Line 7), in the catch-all category of "Other Income" (id. at Line 21), or on Schedule C of the IRS Form No. 1040 (entitled "Profit or Loss from a Business"). Wages would be appropriate if the relationship between the student and grantor was more of that between an employee and an employer (see IRS, http://www.irs.gov/pub/irs-pdf/p15a.pdf, at 6-7 (last visited May 25, 2011), for a list of factors), in which case the student should have received an IRS Form No. W-2, and social security and Medicare taxes should have been withheld. Schedule C would be appropriate if the student was more of an independent contractor, in which case the social security and Medicare taxes would not need to be withheld, but income would be subject to self-employment tax (meaning the student would also need to file Schedule SE of the IRS Form No. 1040). However, characterization of the scholarship as wages or Schedule C income means that the student's primary purpose in working was to produce income or profit. If the student's purpose was, instead, to receive reimbursement for actual expenses that he or she had to substantiate to the grantor, any payment would not be taxable.
Proposed Treasury Regulation § 1.117-6(d)(4) deems a fellowship grant or scholarship to be wages, to the extent it is payment for services, and therefore makes it subject to the withholding and reporting requirements generally applicable to employers. But whether such educational assistance is subject to the Federal Insurance Contributions Act (hereinafter referred to as, "FICA") or the Federal Unemployment Tax Act (hereinafter referred to as, "FUTA"), depends on the organization making the payment and the employment's nature. Prop. Treas. Reg. § 1.117-6(d)(4); citing I.R.C. §§ 3121(b) (defining employment for purposes of FICA tax), 3306(c) (defining employment for purposes of FUTA tax), and the corresponding regulations. In the case of self-employment taxes, which are essentially equivalent to the FICA and FUTA taxes imposed on employees, "while certain scholastic activities may constitute a trade or business . . . amounts paid from a grant [are not necessarily] derived from a trade or business." Spiegelman v Comm'r., 102 T.C. 394, 403 (1994); citing I.R.C. §§ 1401-1403. Thus, a scholarship or fellowship grant can fall outside of the I.R.C. § 117(a) exclusion (for example, because the recipient is a non-degree candidate), and therefore be subject to income tax, but unless it constitutes payment for services (under I.R.C. § 117(c)), it is not subject to FICA or FUTA tax (or the roughly equivalent self-employment tax). Spiegelman, 102 T.C. at 405-06; citing Notice 87-31, 1987-1 C.B. 475 (which also states that, although considered income, such scholarship or fellowship grant is not subject to income tax withholding if I.R.C. § 117(c) does not apply). If I.R.C. § 117(c) does apply, then the employer must withhold income taxes, report the wages of the employee, and file IRS Form No. W-2. Notice 87-31, 1987-1 C.B. 475.
Having addressed the issues of whether a tax return must be filed, and whether educational assistance received is taxable, we now turn to the use of tax benefits to offset the cost of education for which no assistance is available. The first such benefit is the Hope Scholarship Credit. As recently as the year 2009, a student at an institution of higher education (or a program required for enrollment at such an institution) who was carrying a minimum of a half-time work load there, could receive a credit for 100% of the first $2,400 of qualified tuition and related expenses he paid, plus fifty percent of the excess (up to an additional $1,200). I.R.C. § 25A(b)(1), (3), (4), (h)(1); 20 USCA 1091(a)(1); IRS Form No. 8863 (2009). The Hope Scholarship Credit was only allowed for two years with respect to each student (whether the credit was claimed by the student, or another paying the expenses on his or her behalf), and could not be claimed if the student had completed his or her second year of postsecondary education before the beginning of the taxable year at issue. I.R.C. § 25A(b)(2)(A), (C). In addition, students convicted of felony drug offenses were not eligible. Id. § 25A(b)(2)(D). Qualified tuition and related expenses here meant only tuition and fees (not including student activity or athletic fees, or insurance expenses), but the student could be the taxpayer, his or her spouse, or any dependents he or she could claim on a return. Id. § 25A(f)(1)(A), (C).
Beginning inthe year 2010, the Hope Scholarship Credit is no longer available (IRS Pub. No. 970 (2010)), but the American Opportunity Credit and the Lifetime Learning Credit still exist. The American Opportunity Credit has the same definition of an eligible student as the Hope Scholarship Credit. While the credit amount in the American Opportunity Credit is reduced to $2,500 (100% of the first $2,000, plus twenty-five percent of the next $2,000), up to forty percent ($1,000) is refundable (except for certain students claiming the credit on their own returns, either because they are under eighteen or because they did not provide more than half of their own support from their earned income). In addition, the credit can be claimed for the first four years of postsecondary education (though if the Hope Scholarship Credit was claimed in prior years, the number of years it was claimed would cause a corresponding decrease in the number of years the American Opportunity Credit is available). Another beneficial feature of the American Opportunity Credit is that qualified expenses include not only tuition and fees (including student activity fees here, if required for enrollment or attendance), but also books, equipment and supplies, if course-related. Though these additional expenses need not be purchased at the educational institution, they must be required for the course (and not merely recommended by the professor). IRS Pub. No. 970 (2010).
The Lifetime Learning Credit also has the same definition of an eligible student as the Hope Scholarship Credit (except that felony drug convictions are not disqualifying), and the same definition of qualified expenses as the American Opportunity Credit. The difference here is that this credit can be used for postgraduate expenses as well as undergraduate, and that the courses need not lead to a degree. Qualifying courses can be merely to improve or acquire job skills, but must still be at the same type of educational institution as with the other two credits. The credit amount is further reduced to $2,000 (twenty percent of the first $10,000, for all students), and, like the Hope Scholarship Credit, is entirely nonrefundable, but there is no limit on the number of years it can be claimed. IRS Pub. No. 970 (2010).
All three credits (the Hope Scholarship, American Opportunity and Lifetime Learning Credits) do not apply to that portion of qualified tuition and related expenses that are paid with: qualified scholarships that are non-taxable under I.R.C. § 117; other educational assistance; or, tax-free payments other than lifetime or testamentary gifts. Id. § 25A(g)(2). In addition, the credits follow the dependent exemption, such that a student may not receive a credit, even if he paid the expenses, if he is claimed as a dependent on another person's return. In that case, the other person is treated as having paid the expenses (id. § 25A(g)(3)), unless the other person foregoes claiming the exemption (and then the student can claim the credit). IRS Pub. No. 970 (2010). Finally, it should be noted that one cannot claim more than one credit for the same expense.
On the other hand, if a deduction is claimed for a particular expense, none of the credits (see supra) can be claimed for the same expense (I.R.C. § 25A(g)(5)). The reverse is also true, and, as is the case with the credits, more than one deduction cannot be claimed for the same expense. In fact, the tuition and fees deduction (see infra) cannot be claimed for one expense, even if the expense for which a credit is claimed is different, so long as the student is the same. IRS Pub. No. 970 (2010). In addition, as with the credits, the deductions do not apply to that portion of qualified expenses that are paid with: qualified scholarships that are non-taxable under I.R.C. § 117; other educational assistance; or, tax-free payments other than lifetime or testamentary gifts. IRS Pub. No. 970 (2010).
The first of the two deductions to consider is the tuition and fees deduction. This deduction is similar to the Lifetime Learning Credit, but is limited to the first $4,000 of qualified expenses, and only reduces the amount of income subject to tax (rather than reducing the tax dollar-for-dollar, as with a credit). The deduction follows the dependent exemption here, as with the credits (see supra), except that a student cannot claim the deduction because another person chooses not to claim the dependent exemption for the student, if that person was nevertheless eligible to claim the exemption (with the result that no one would be able to claim the deduction). Nor can anyone claim the deduction if the student paid the expenses but is claimed on another's return. IRS Pub. No. 970 (2010).
The deduction for business expenses is broader than the tuition and fees deduction and the education credits, as it includes transportation to and from school. But the business expenses deduction is also narrower because the education must be work-related, and, unless the student is self-employed, can only be taken if: (1) he or she itemizes deductions; and, (2) the expenses, along with other job and miscellaneous expenses, are greater than two percent of the student's adjusted gross income. IRS Pub. No. 970 (2010).
The process of determining whether education qualifies for the business expenses deduction is more difficult, as one of two qualifying tests, and neither of two disqualifying tests, must be met. The qualifying tests are that the education is either required to retain the student's job, salary or status (whether by his or her employer or the law, but in either case a bona fide business purpose must be served), or that the education improves or maintains skills required for the student's present work. The disqualifying tests are that the education must neither qualify the student for a new trade or business (even if he or she does not intend to enter it), nor be required for the student's current trade or business (due to minimum educational requirements imposed by law, business standards or the student's particular employer). However, these disqualifying tests are not necessarily met solely because the education could, or does lead to a new degree.
Under the first disqualifying test, a distinction is drawn between temporary and indefinite absences from work. A temporary absence, or up to one year, means that any education during that time can still be considered to improve or maintain skills required for present work. On the other hand, if the absence is indefinite, or more than one year, than any education during that time will be deemed to qualify the student for a new trade or business (even if the student returns to the same work he or she had before the absence). Under the second disqualifying test, students are not required to meet the minimum educational requirements for their work more than once, for tax purposes here at least. Thus, if the requirements become more burdensome after the student has already satisfied them, education thereafter will not be deemed to fall under the disqualifying test for education meeting minimum educational requirements. IRS Pub. No. 970 (2010).
The transportation expenses that can be deducted for qualifying work-related education include those incurred in going from work to school. In addition, if the student is regularly employed and attends school on a temporary basis, expenses incurred in then returning home, or in going from home to school and back, are included. Expenses related to overnight travel, however, are excluded here (and are instead deductible under the rules governing employee business expenses for travel, lodging and meals, which are beyond the scope of this article). To be a temporary student, one must attend school for one year or less, under a realistic expectation at the time of entering. Then, the student must either do so in reality, or, at a later date, develop a realistic expectation of attending school for longer (in which case the attendance is only temporary until the expectation so changes). However, the student cannot avoid disqualification for the status of a temporary student by actually attending school for a year or less, if the realistic expectation at the outset was that attendance would be for longer. IRS Pub. No. 970 (2010).
Gift Taxation
The source of funds for a student's education, other than those acquired through educational assistance, may raise gift tax consequences in addition to the income tax issues discussed above. A child or young adult's receipt of funds for school from a parent, guardian, relative or even a stranger does not generally give rise to income tax consequences to the student. This is true whether the funds are given to the student, or paid directly to the educational institution. But a gift can create gift tax liability for the person that made it, often called the "donor," if the gift was not provided by a person with a legal duty to support the student (such as a parent or guardian).
Unlike with income tax returns, there are not different minimum income levels giving rise to gift tax filing requirements for dependents and non-dependents. In fact, the amount of one's income bears no relation to the need to file a gift tax return; only the amount, timing and purpose of the gift are important. If a student receives a gift for use with his educational expenses, a gift tax return must be filed by the donor if it was in an amount greater than the I.R.C. § 2503(b) annual exclusion amount, which is $13,000 for the years 2010 and 2011 (Rev. Proc. 2009-50, § 3.30(1), 2010-40, § 3.21(1), respectively). The two exceptions to this filing requirement of relevance here are if the gift qualifies as a transfer for educational expenses under I.R.C. § 2503(e), or if the donor has a sufficient portion of his applicable exclusion amount remaining to cover the excess of the amount of the gift over the annual exclusion amount. Id. § 2505. A third relevant exception, though beyond the scope of this article, is if the donor and the recipient of the gift (often called the "donee") are married at the time of the gift. Id. § 2523(a).
The annual exclusion under I.R.C. § 2503(b) applies to each donee, though several gifts to the same donee by a donor, during the course of one year, will be aggregated. In order to qualify, the gift must be complete under applicable state law, and be a gift of a present interest. A present interest is defined as "an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property (such as a life estate or term certain)." Treas. Reg. § 25.2503-3(b). I.R.C. § 2503(e) gifts for education can be unlimited in amount and frequency, having no bearing on the annual exclusion amounts (meaning they can be made in addition to annual exclusion gifts to the same individual. Treas. Reg. § 25.2503-6(a). However, the payment of the I.R.C. § 2503(e) gift must be made for tuition (". . . amounts paid for books, supplies, dormitory fees, board, or other similar expenses . . . do not constitute direct tuition costs"), and directly to an educational institution. Treas. Reg. § 25.2503-6(b)(2). Such institutions are those within the same broad category as that for which qualified scholarships can be received tax-free under I.R.C. § 117(a) (see supra). Id. § 2503(e)(1), (2)(A).
Even if gifts exceed the annual exclusion amount, and do not satisfy the requirements of I.R.C. § 2503(e), the gifts can still be tax-free so long as the donor has not used so much of his applicable (lifetime) exclusion amount as to be unable to cover the taxable part of the gifts. The applicable exclusion amount was $1 million in the year 2010, but was recently reunified with the estate tax exclusion amount (which is beyond the scope of this article), for a combined total of $5 million in the year 2011. Public Law 111-312 (2010), §§ 301, 302, 304. The gift tax exclusion can be used in piecemeal throughout a donor's life, or to cover a single gift, but either way its use is mandatory each time a gift would otherwise result in gift tax. In other words, a donor cannot choose to be taxed on earlier gifts and "save" the applicable exclusion amount for later gifts. Rev. Rul. 79-398.
Conclusion
Measured analysis and careful planning can ease the stress surrounding the financing of a student's education. The income tax consequences of the student's filing status, receipt of educational assistance, and qualification for credits and deductions must all be considered, as well as the potential gift tax consequences if funds were received from another person. With all of these factors, and the tax law in a constant state of flux due to the legislative process and new court decisions, it is always recommended that an attorney, C.P.A., or other trusted tax practitioner conversant in this area be consulted prior to taking any action. This article is meant to be an informative discussion of current tax law and is not being offered as tax or legal advice.