Treasury Department Provides Advice on Maximizing Education Tax Credits by Proper Allocation of Scholarships

(Parker Tax Publishing November 2016)

The Treasury Department has issued a fact sheet discussing ways students can maximize education credits by allocating scholarships, such as the Pell Grant, between tuition and living expenses. The Treasury noted that allocating grants to living expenses, rather than to tuition and related expenses, can increase available education credits, effectively offsetting the income increase from allocating the grant to living expenses. Treasury Fact Sheet - Interaction of Pell Grants and Tax Credits.

Background

The American Opportunity Tax Credit (AOTC) is a tax credit under Code Sec. 25A that is generally available to students in the first four years of postsecondary education to offset costs for "qualified tuition and related expenses" (QTRE). Such expenses include tuition, required fees, and course materials. The AOTC provides a 100 percent credit for the first $2,000 of QTRE and a 25 percent credit for the next $2,000, for a total credit of up to $2,500. Forty percent of the otherwise allowable AOTC, up to $1,000, is refundable. In addition, students who are not eligible for the AOTC may be eligible for a Lifetime Learning Credit (LLC) in any year of postsecondary study. The non-refundable LLC is equal to 20 percent of up to $10,000 of qualifying expenses per tax return.

The Pell Grant is a government scholarship provided to eligible students based in part on financial need. For the 2015 to 2016 award year, the maximum grant was $5,775. This amount increased to $5,815 for the 2016 to 2017 award year. A student can choose whether to allocate his or her Pell Grant (and many other scholarships) to tuition, fees, and course related materials or to living expenses when filing a tax return. If the student allocates the Pell Grant or other scholarships to tuition and fees, the scholarship reduces the amount of expenses eligible to be used to claim education-related tax credits. If allocated to living expenses, however, then the scholarship becomes taxable for the student. Students have this choice regardless of how the school applies the scholarship.

Pell Grants can be treated in one of two ways for tax purposes:

(1) Tax-free and subtracted from AOTC-eligible expenses: Pell Grants allocated to QTRE are excluded from taxable income, but they are also subtracted from QTRE for purposes of the AOTC and LLC, potentially reducing the credit for which students are eligible; or

(2) Taxable and not subtracted from AOTC-eligible expenses: Pell Grants allocated to living expenses such as room and board are included in the student's taxable income and are not subtracted from QTRE for purposes of the AOTC and LLC, potentially increasing the credit for which students are eligible.

Interaction of Pell Grants and Tax Credits

According to the Treasury Department, many students would benefit by claiming at least a portion of their QTRE for the AOTC, even if that requires including some of their Pell Grant (or other scholarships) in taxable income. If a student's QTRE exceeds his scholarships by $4,000 or more, the student can claim the maximum AOTC without having to include any scholarship in income. But if QTRE minus scholarships is less than $4,000, the student may benefit by including a portion of the scholarship in income in order to claim a larger AOTC.

Under Reg. Sec. 1.25A-5(c), the student generally can treat Pell Grant funds to have been used for non-QTRE, such as room and board, simply by including the funds in income. Because scholarships grants that the student includes in income don't reduce the student's QTRE available to determine the AOTC, including enough of the grant in income to report up to $4,000 in QTRE could increase the credit by enough to increase an available tax refund or reduce the amount of tax owed, even considering any increased tax liability from the additional income. However, the increase in tax liability as well as the loss of other tax credits may be greater than the additional AOTC and may cause a potential tax refund to decrease or the amount of tax owed to increase.

The Treasury noted that the tax-minimizing allocation of Pell Grants and other scholarships between QTRE and living expenses depends on a number of factors, including the terms of each scholarship, the amount of scholarships and expenses, the student's marginal tax rate and income tax available for use against the non-refundable share of AOTC or LLC, and, in the case of tax dependents, the parents' income tax before AOTC or LLC. The calculation of the optimal strategy is especially complicated, the Treasury stated, because in the case of a dependent student it may depend on two tax returns and because a student's marginal tax rate may change depending on how much of the scholarship is included in income.

For a discussion of the American opportunity tax credit, see Parker Tax ¶101,115.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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