The Scholarship Trap for Foreign Students

Many U.S. colleges and universities recruit foreign students, especially for graduate programs and athletics. Such students often receive full scholarships that include room and board, making them subject to U.S. income taxes. These students may be unfamiliar with the U.S. tax system, but they need to understand how some financial aid can be taxed, particularly if their homeland lacks a tax treaty with the United States.

Generally, the portion of a scholarship paid for tuition or related expenses under IRC § 117(b)(2) is not taxable for any degree candidate, while any portion paid for room and board or other nonqualified expenses is subject to U.S. taxes. Nonqualified expenses also include travel, research, clerical help or equipment or supplies not necessary for enrollment or attendance. In addition, the portion of a scholarship that is compensation for teaching or other services is taxable.

U.S. colleges and universities are not required to report scholarships to the IRS if the recipient is a U.S. citizen or resident alien. But for the majority of foreign students who are nonresident aliens, the IRS has established a reporting and withholding system, generally at a rate of 14%. See IRC § 1441(b). The university reports the income and taxes withheld on an information return, Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding .

A NEGATIVE ACCOUNT BALANCE
This withholding can be a problem for many foreign students. Most scholarships that include room and board are for exactly those costs, with no additional money included for taxes. Therefore, the withholding is often charged against a student’s university account, creating a negative balance. Usually, the deficit must be cleared for the student to graduate or receive a college degree or transcript. Unaware of the extra cost, foreign students often do not budget for it. The problem is compounded for the many foreign students who hold a student visa, which prevents them from working for a U.S. employer to earn money.

Under some countries’ tax treaties with the United States, room and board scholarship income is not subject to taxation. Even for students from those countries, however, the university may issue a Form 1042-S and withhold taxes unless the student alerts it that withholding is not required. Such notification is by Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding . Form W-8BEN is required for foreign students to claim an exemption from withholding when they are from countries with which the United States has an income tax treaty. Therefore, it is the foreign students’ responsibility to know the terms of their country’s tax treaty with the U.S. Depending on the treaty, a university may report a zero amount on a 1042-S. IRS publication 901, U.S. Tax Treaties , may be useful in determining a student’s status, as may be Volunteer Income Tax Assistance training materials at www.irs.gov/app/vita/foreign_student_module.jsp . The amount of treaty benefit is unlimited in most cases. However, most treaties limit how long the benefit is available, typically a maximum of five years.

FILING 1040NR
Nonresident aliens with taxable income generally are required to file a return on Form 1040NR or 1040NR-EZ. This requirement is not well-understood by many foreign students, who often mistakenly file Form 1040, or by some tax return preparers, whose electronic preparation systems likely won’t accept a 1040NR. A 1040NR cannot be filed electronically with the IRS, either.

In computing their taxable income on 1040NR, foreign students typically can deduct only a personal exemption, which for 2008 is $3,500. No standard deduction is permitted, so any income in excess of $3,500 will usually be taxed at the 10% rate. For example, a student who received a scholarship including $7,500 to cover room and board would have $1,050 ($7,500 x 14%) withheld and charged against a student account. When filing Form 1040NR, this studen would compute an income tax of approximately $400 [($7,500 - $3,500 personal exemption) x 10%] and receive a refund of $650 ($1,050 - $400).

Other problems for foreign student scholarship recipients may include the lack of an individual tax identification number (ITIN). Unless an exception applies, Form W-7, Application for IRS Individual Taxpayer Identification Number , must be accompanied by an original, completed return. The IRS will assign an ITIN, which the Service says can take up to 10 weeks, and then process the return. An ITIN is also required on Form 1042-S to claim a zero or reduced rate of withholding under a tax treaty.

By Marc I. Lebow, CPA, Ph.D., and Michael McLain, CPA, DBA, both of Hampton University, Hampton, Va., and Wayne Schell,  CPA, Ph.D., of Christopher Newport University, Newport News, Va. Their e-mail addresses, respectively, are marc.lebow@hamptonu.edu, mcklaipm@inteliport.com and wschell@cnu.edu.