Tax preparers may have problems determining the dependency status of a student who lives with, but is not the child of, a taxpayer, especially when the student has proceeds from a scholarship or tax-deferred education account or loan. While this is not a common situation, such a scenario may require deeper consideration of the source of the funds.
College scholarships for tuition and fees to enroll in or attend an eligible educational institution and for course-related fees, books, equipment and supplies required for its courses are considered tax-free to the student and not included in income. However, scholarships or portions of them received for room and board, travel, research, clerical help or equipment not required for enrollment or attendance must be included as earned income. But whether or not a scholarship is recognized as taxable income, it and educational expenses figure in the support tests for dependents. A qualifying child (QC) must not have provided more than half of his or her own support during the tax year (IRC § 152(c)(1)(D)). Similarly, a taxpayer must have provided more than half the support of a qualifying relative (QR) (section 152(d)(1)(C)).
Section 152(f)(5) prescribes a special treatment for scholarships with regard to the support tests. If the recipient is a fulltime student at a qualifying educational organization as defined in section 170(b)(1)(A)(ii) and “a child of the taxpayer” (section 152(f)(5)(A)), any scholarship is excluded from the support tests. For this purpose, a child of the taxpayer is defined as a son, daughter, stepson, stepdaughter, eligible foster child, a legally adopted child or an individual placed with the taxpayer for adoption (section 152(f)(1)). Descendants of these individuals are not included, even though they are in the relationship tests for QCs and QRs.
Thus, for purposes of the support test, the scholarship exclusion does not apply to a nonchild QC or QR, such as the taxpayer’s grandchild, brother, sister or half- or stepbrother or stepsister.
Example 1. Mark, a full-time college student under age 24, lives with his grandmother, Lenore. He is not a qualifying child of either of his parents but meets the other tests to be a QC of Lenore. Because he is not Lenore’s child, a college scholarship he receives must be considered in determining whether he meets the support test. What is less clear is how it is considered. Worksheet 3-1, “Worksheet for Determining Support,” in IRS Publication 17, Your Federal Income Tax (2010), includes in the dependent’s funds “those belonging to the person you supported, including income received (taxable and nontaxable)” (line 1) but excludes “the amount others provided for the person’s support” (line 23). A scholarship might be considered either, and, although the IRS has not clarified the situation, the choice could determine the outcome. (Although the worksheet is for determining the QR support test, the section of Publication 17 describing the QC support test calls the worksheet “helpful” in determining whether a child provided more than half of his or her support.)
Example 2. Using the facts in Example 1, assume that Mark and Lenore list Mark’s scholarship of $7,500 as funds belonging to him and used for his support. Mark also earned $4,000 during the year from a part-time job, all of which he used for his own support. They calculate his support as follows:
- Portion of Lenore’s household expenses allocated to Mark: $10,000
- Mark’s other expenses paid by Lenore: $500
- Mark’s other expenses paid by him: $4,000
- Mark’s educational expenses paid by scholarship: $7,500
- Mark’s total cost of support: $22,000
- Half of Mark’s support: $11,000
- Funds belonging to Mark and used for his own support: $11,500
If the scholarship is considered as from Mark for his support, Mark cannot be a QC of Lenore, since he provides more than half his own support. In this case, he can’t be considered a QR, either. Not only did Lenore not provide more than half his total support, but Mark fails the gross income test for a QR ($3,650 maximum in 2010).
If, on the other hand, the scholarship is considered as coming from a third party, Mark is a QC, since the other support he provided, $4,000, is less than $11,000. He still couldn’t be considered a QR, however, since Lenore wouldn’t have provided more than half his support.
Tip. Since the IRS has not provided guidance on the source of scholarships for nonchild QCs and QRs in support calculations, taxpayers can use a reasonable method. For these purposes, the most favorable treatment usually is to consider the funds as provided by others.
LOANS AND SECTION 529 AND COVERDELL DISTRIBUTIONS
Regardless of relationship to the taxpayer, a student who obtains a loan in his or her name and uses the proceeds to pay college expenses must count the proceeds as student-provided support (IRS Publication 17, Your Federal Income Tax (2010), Example 2, page 32).
The IRS has provided no guidance on whether distributions from section 529 qualified tuition plans (QTPs) and Coverdell accounts (CAs) are treated as provided by the student or by the account owner. However, the taxpayer might take the position that it is reasonable for the source of the funds to be considered the account owner, which for a QTP is usually the parent. A CA, however, is treated as a custodial account, meaning the account beneficiary (the student) becomes the account owner at age 18 to 21, depending on laws in the state of residence. The treatment of section 529 and Coverdell account distributions for the support test is discussed in more detail in the August 2010 issue of The Tax Adviser (“Dependency Exemption Issues for College Students,” page 546).
By James M. Hopkins, CPA, (firstname.lastname@example.org) professor of accounting, Morningside College, Sioux City, Iowa.
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