The American opportunity tax credit and lifetime learning credit may seem to involve straightforward calculations; however, there is more to them than meets the eye. This article explores a tax strategy of electing to include in gross income certain otherwise excludable scholarships or grants to, in certain cases, maximize the net tax benefit from these education credits.
The instructions to Form 8863, Education Credits (American Opportunity and Lifetime Learning Credits), summarize this strategy, stating:
You may be able to increase an education credit and reduce your total tax or increase your tax refund if the student (you, your spouse, or your dependent) chooses to include all or part of certain scholarships or fellowship grants in income. ... The scholarship or fellowship grant must be one that may (by its terms) be used for expenses other than qualified education expenses (such as room and board).
Similar instructions can be found in IRS Publication 970, Tax Benefits for Education. This strategy can significantly affect the tax outcome of a taxpayer, as both education credits provide significant tax benefits:
- The American opportunity tax credit ("AOTC" in the accompanying tables) offers a credit for 100% of the first $2,000 in qualified education expenses and an additional 25% on the next $2,000, for a combined maximum tax credit of $2,500. The available credit is 40% refundable (i.e., up to $1,000). The American opportunity tax credit is limited to a student's first four years of higher education.
- The lifetime learning credit ("LLC" in the accompanying tables) offers a credit for 20% of up to $10,000 in qualified education expenses. Thus, a maximum credit of $2,000 is available to qualifying students. Eligible students enrolled in courses at an eligible college, university, vocational school, or other postsecondary institution (including courses to acquire or improve job skills) can claim the lifetime learning credit. There is no limit on the number of years the student can claim the credit.
Regs. Sec. 1.25A-5(c)(1) provides that, in determining the amount of an education tax credit, qualified tuition and related expenses for any academic period must be reduced by the amount of any tax-free educational assistance allocable to that period. For this purpose, tax-free education assistance means a qualified scholarship that is excludable from income under Sec. 117 and certain other excludable educational assistance.
Sec. 117 provides that gross income does not include any amount received as a qualified scholarship by an individual who is a candidate for a degree at an educational organization as defined for purposes of the charitable contribution deduction in Sec. 170(b)(1)(A)(ii). Under Sec. 117(b)(1), in general, the term "qualified scholarship" means any amount received by an individual as a scholarship or fellowship grant to the extent the individual establishes that, in accordance with the conditions of the grant, the amount was used for qualified tuition and related expenses.
However, just because any nontaxable scholarship or grant can be applied to qualified education expenses when calculating education credits does not necessarily mean it must be applied.
Regs. Sec. 1.25A-5(c)(3) provides that scholarships and grants are to be treated as excludable from taxable income under Sec. 117 except to the extent the scholarship or fellowship grant (or any portion of it) may or must be applied, by its terms, to expenses other than qualified tuition and related expenses (such as room and board), and the student reports the grant (or the appropriate portion of it) as income on the student's return, if the student is required to file a return.
In other words, Regs. Sec. 1.25A-5(c)(3) gives students an opportunity to increase their education credits by allowing them to apply their scholarship or grant to expenses other than qualified education expenses. In some cases, including the scholarship or grant amount in income and thereby increasing the qualified education expenses that can be claimed toward the credit yields a greater tax benefit than excluding the scholarship or grant from income.
TYPES OF QUALIFIED SCHOLARSHIPS AND GRANTS
There are hundreds, if not thousands, of types of scholarships and grants, both on the federal and state level. Two criteria are applied in determining the eligibility of each scholarship or grant for use in this strategy:
- The scholarship or fellowship grant must qualify as tax-free under Sec. 117(b)(1), as defined earlier.
- The terms of the scholarship or grant must allow it to be applied to nonqualified expenses.
If further information is required to substantiate the eligibility of a scholarship or grant, taxpayers can contact the student's financial aid office to request its terms.
QUALIFIED TUITION AND RELATED EXPENSES
Regs. Sec. 1.25A-2(d)(2)(i) provides that the test for determining whether any fee is qualified tuition or a related expense is whether it is required to be paid to an eligible educational institution as a condition of the student's enrollment or attendance at the institution.
Regs. Sec. 1.25A-2(d)(2)(ii) further provides that related expenses include fees for books, supplies, and equipment used in a course of study only if the fees must be paid to the eligible educational institution for the enrollment or attendance of the student at the institution.
In contrast to Regs. Sec. 1.25A-2(d)(2)(ii), Prop. Regs. Sec. 1.25A-2(d)(3) and the Form 8863 instructions provide that, regarding the American opportunity tax credit, qualified education expenses include amounts spent on books, supplies, and equipment needed for a course of study, whether or not the materials are purchased from the educational institution. However, the requirement that the fees be paid to the eligible educational institution still pertains to the lifetime learning credit, according to the instructions.
NONQUALIFIED EDUCATION EXPENSES
Regs. Sec. 1.25A-2(d)(3) provides that qualified education expenses exclude personal expenses, including room and board, insurance, medical expenses (including student health fees), transportation, and other similar personal, living, or family expenses.
Neither the regulations nor Publication 970 indicates what nonqualified expenses can be used in offsetting qualified scholarships or grants. Without clear guidelines on the matter, the authors assume it is best to rely on the terms of the scholarship or grant regarding what nonqualified expenses it can be used to pay.
The strategy of allocating scholarships and grants between qualified and nonqualified expenses can become a tedious calculation due to numerous factors that come into play when trying to achieve the best tax result. Tax practitioners need to be mindful of factors such as the student's tax rate, the student's dependency status, and all of the various qualified and nonqualified income and expenses.
A married couple both attend college and have one dependent, a qualifying child under age 17. The couple meet all other requirements to claim either of the education credits (which are analyzed here together for comparison, although a taxpayer may not claim both with respect to the same student in the same tax year).
The couple have earned income of $20,000. They have a combined $8,000 ($4,000 each) in qualified education expenses and $6,000 in nonqualified education expenses. The wife received $3,500 and the husband received $2,500 in qualified scholarships and grants. The scholarships and grants by their terms can be used for nonqualified expenses.
The college applied the scholarships and grants against qualified tuition and related expenses. If the couple agreed with this allocation, they would end up with $500 ($4,000 — $3,500) and $1,500 ($4,000 — $2,500), respectively, remaining in qualified education expenses to use in calculating the education credits. This approach results in an $800 American opportunity tax credit (see the "Original" column in the table "Family With Both Spouses Attending College").
Family with both spouses attending college
To maximize their credit, the couple can use their combined $6,000 of scholarships and grants to pay for $6,000 in nonqualified education expenses and report the $6,000 as taxable income. The couple's qualified education expense would no longer be reduced by the qualified scholarships and grants. Thus, they could each claim $4,000 in qualified education expenses when calculating the education expenses (see the results in the "AOTC" column in the table "Family With Both Spouses Attending College"). This approach increased the couple's overall tax refund by $937. Notice this strategy would have a negative effect if used to claim the lifetime learning credit (see the "LLC" column in the same table).
- Nontax considerations may weigh against this strategy. Including scholarships and grants in income may affect the amount of need-based educational assistance the taxpayer may receive in the future. Increasing a student's adjusted gross income (AGI) can affect the calculations used in determining the amount of needs-based assistance awarded to that student.
- Watch out for the effects on the earned income tax credit (EITC) for those individuals qualifying for both credits. Increasing the couple's income could decrease the EITC beyond the gains received from the increased education credits.
- This increase in income can also affect an individual's state income tax. While the federal refund in the table "Family With Both Spouses Attending College" was increased, any effect of the increased income on state income taxes is not shown.
A single student attended college in the spring semester as an undergraduate and later in the fall as a graduate student at the same institution. The student earned $24,000 during a summer sales job. He has $7,000 in qualified education expenses and $10,000 in nonqualified education expenses and received $8,000 in scholarships and grants. The student assumed he had to apply scholarships and grants to the qualified education expenses, leaving him with no qualified education expenses to use in claiming the credit (see the results in the "Original" column in the table "Student in Undergraduate and Graduate School in the Same Year").
Student in undergraduate and graduate school in the same year
The student later amended his return by filing a Form 1040X, Amended U.S. Individual Income Tax Return, to maximize his education credits. This example requires a different approach when calculating the American opportunity tax credit versus the lifetime learning credit.
If the student claims the American opportunity tax credit, he should not apply the full $8,000 in scholarships and grants to nonqualified expenses. It is better to allocate $3,000 toward qualified education expenses and the remaining $5,000 to nonqualified expenses. This allows the student to retain $4,000 ($7,000 — $3,000) in qualified education expenses, the maximum amount allowable in calculating the American opportunity tax credit. This allocation creates a $1,900 tax benefit when compared with the original return (see the table "Student in Undergraduate and Graduate School in the Same Year").
However, if the student could not claim the American opportunity tax credit, the lifetime learning credit could create a tax benefit. To maximize this credit, the $8,000 in scholarships and grants should be allocated to living expenses and included in income, thus allowing the $7,000 in qualified education expenses to apply toward the lifetime learning credit. The credit would be $1,400 ($7,000 × 20%). However, the credit is largely offset by the increased tax due to the $8,000 of additional income. The net result is a tax benefit of $440 compared with the original return. However, taxpayers in states with an income tax may find the increased state tax outweighs the benefits of pursuing this strategy for the lifetime learning credit.
This student was an undergraduate for part of the year and a graduate for the remainder of the year. Under these circumstances, colleges will send out a Form 1098-T, Tuition Statement, with box 9 checked, listing the student as a graduate student. The Form 1098-T is just a guide. As such, in practice, we attach information to the return to substantiate that the student was an undergraduate student for half the year. For more guidance on Form 1098-T, see the section "Form 1098-T Reporting Issues" later.
A married couple have three dependents, two in high school and one attending college full time. The child attending college meets all the requirements to claim the education credits.
The child in college has $4,000 in qualified education expenses and received $10,000 in qualified scholarships and grants. The child's living expenses are $15,000. The child had other taxable income of $5,000 in wages during the year and is claimed as a dependent on the parents' return.
If the parents apply the $10,000 in qualified scholarships and grants against the $4,000 in qualified education expenses, no American opportunity tax credit or lifetime learning credit would be available (see the table "Dependent With Parents Claiming Education Credit")
Dependent with parents claiming education credit
Now assume the student allocated the $10,000 of scholarships and grants to living expenses rather than the qualified education expenses. This allows the full $4,000 in qualified education expenses to be taken into consideration for the education credit. However, the $10,000 of scholarships and grants would have to be included on the student's return. Under other circumstances, the standard deduction for individuals claimed as a dependent is the greater of $1,050 or the sum of $350 plus the individual's earned income, limited by the standard deduction. However, for purposes of calculating the standard deduction for dependents, under Prop. Regs. Sec. 1.117-6(h), taxable scholarships and grants are treated as earned income (see also H.R. Conf. Rep't No. 841, 99th Cong. 2d Sess. (1986), at II-17). Under the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, the student dependent can now claim the $12,000 standard deduction, leaving only $3,000 subject to tax. In comparison, before the passage of the TCJA, in 2017, the student would have had $8,650 of taxable income ($15,000 of AGI, less the $6,350 standard deduction). The combined effect on the parents' and student's return in 2018 of allocating the $10,000 to income would generate a tax benefit in the amount of $2,200 (see the table "Dependent With Parents Claiming Education Credit"). Note: Due to the parents' high income, the lifetime learning credit would not be beneficial to try to maximize in this scenario; as such, it was not included in the table.
- When calculating education credits for a dependent student, preparers should examine the tax effect on returns for both the parents and the student to determine if the combined taxes generate a combined tax benefit.
- If, in this example, the other two children took college credits in high school and each had $1,000 in education expenses, it may be best to have them claim the lifetime learning credit. The American opportunity tax credit is only available for four years, so they would want to claim the credit only in years when the maximum $4,000 in qualfied expenses would be most likely to be used. They can choose to take the American opportunity tax credit or the lifetime learning credit on a per-student, per-year basis.
The facts are the same as in the previous example, except that the parents' AGI is above the limit to claim the American opportunity tax credit and the lifetime learning credit. It might now be more beneficial to have the child claim the credit on his or her own return rather than that of the parents. The parents would lose the family tax credit for the student, increasing their tax, but the student would be eligible to claim the American opportunity tax credit or the lifetime learning credit. In this scenario, the combined tax liability would decrease by $500 because the $1,000 increase in the refundable credit on the student's return outweighs the parents' loss of the $500 family tax credit (see the table "Dependent With Parents Over Credit Phaseout"). Before the TCJA's passage, this scenario may not have been as favorable an option. Then the parents would also have had to give up their $4,050 (for 2017) dependency exemption. The TCJA suspended dependency exemptions for tax years 2018 through 2025.
Dependent with parents over credit phaseout
- The student can claim the credit only if he or she provides more than half of his or her own support. Student loans and other means of paying for living expenses can be considered to determine compliance with the more-than-half-support rule.
- The credit can be claimed on the return of a parent only if the parent claims the student as a dependent. If the student claims the credit on his or her return, the parents cannot claim that student as a dependent.
FORM 1098-T REPORTING ISSUES
Form 1098-T reports payments received by an eligible educational institution for qualified tuition and related expenses, any adjustments, and the amount of scholarships or grants a student receives. Educational institutions are required to file a Form 1098-T for each student who is enrolled and for whom a reportable transaction is made, with some exceptions.
These exceptions are spelled out in the instructions to Form 1098-T: "You do not have to file Form 1098-T or furnish a statement for: Courses for which no academic credit is offered, even if the student is otherwise enrolled in a degree program; nonresident alien students, unless requested by the student; students whose qualified tuition and related expenses are entirely waived or paid entirely with scholarships."
In practice, we have found that educational institutions might not issue a Form 1098-T to a student whose combined scholarships and grants exceed his or her tuition and related expenses. Students in such instances are still eligible to claim education credits, according to the instructions to Form 8863:
A taxpayer may claim education benefits if the student does not receive a Form 1098-T because the student's education institution is not required to send a Form 1098-T to the student under existing rules. ... A taxpayer may claim one of these education benefits without a Form 1098-T if the taxpayer otherwise qualifies, can demonstrate that the taxpayer was enrolled at an eligible educational institution, and can substantiate the payment of qualified tuition and related expenses.
In practice, we have found that schools will provide either Form 1098-T substitute documentation, a financial summary breakout of expenses and scholarships/grants, or other documentation, or students can log on to their school's financial account summary page and print the details for the academic period in question. In these situations, we have attached notes to the tax returns stating why a valid Form 1098-T was not presented to the student and how the education credits were calculated.
Another Form 1098-T issue is that the reported amounts in box 5, "Scholarships or Grants," do not provide sufficient information to maximize education credits. The reported amounts do not distinguish between the types of grants or scholarships a student receives; they may even include nonqualified scholarships. Practitioners will need to confirm with their clients the terms of each grant or scholarship they receive that is reported in box 5. If students are not sure, they can contact their college's financial aid office to determine the terms.
About the authors
Cody Gamboa, CPA, and Travis Wheeler, CPA, M.Acc., are managers at Rudd & Co. PLLC in Rexburg, Idaho.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.
- 1040 Tax Return Workshop (#746413, text; #153803, online access; text and video, #113639)
- Education Planning (#166680, online access)
- Individual Tax Fundamentals — Tax Staff Essentials (#157584, online access)
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