Federal Taxation of financial aid for students

"Federal Taxation of financial aid for students" submitted by SchoolGrantsfor Editorial Team and last updated on Monday 9th January 2012

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Financial aid taxation for students enrolled in colleges, universities, and other post secondary educational institutions

Most financial aid provides income to students, so the question arises whether they must pay federal income taxes on it. Some aid also involves employment, so students may have to pay Federal Insurance Contribution Act (FICA) taxes as well. Scholarships and fellowships (including grants) generally are not taxable if they are used for tuition and required course expenses. Tuition reductions also are not taxed. However, both types of aid are subject to income and sometimes FICA taxes to the extent that they represent payment for services. Neither veterans’ education benefits nor loans are taxable; however, loan amounts that are forgiven or otherwise discharged generally are subject to income taxes. Work-study awards are subject to income and sometimes FICA taxes. Employer tuition reimbursements are taxable unless they qualify as a deductible business expense or are provided through an employer education assistance program under Section 127 of the Internal Revenue Code.

Student aid that is taxable is not necessarily taxed; at least not to the extent it is included in gross income on income tax returns. Taxpayers can offset some portion of taxable income with their personal exemption and their standard deduction or itemized deductions.

Scholarships and Fellowships

Scholarships and fellowships include awards based upon financial need (such as Pell grants) as well as those based upon scholastic achievement or promise (such as National Merit Scholarships). They can be excluded from taxpayers’ gross income for income tax purposes provided that (1) the taxpayer is a degree candidate and (2) the amounts are used for “qualified tuition and related expenses.” These expenses include tuition and fees required for enrollment or attendance as well as fees, books, supplies, and equipment required for courses. They do not include room, board, or incidental expenses.

If scholarships or fellowships have a requirement for the performance of services (teaching, research, or anything else) the portion that represents payment for such services must be included in gross income. It makes no difference whether the service is to be performed before, during, or after the scholarship or fellowship period. It also makes no difference whether the service requirement applies to all students or is necessary for attaining a degree. The portion representing payment for services may be subject to FICA taxes as well.

Tuition Reductions

Tuition reductions for employees of educational institutions can be excluded from gross income if they are (1) restricted to education below the graduate level (with one exception discussed below), (2) do not discriminate in favor of highly compensated employees, and (3) do not apply to amounts representing payment for services.5 The last restriction is identical to the one just discussed for scholarships: amounts that represent payment for teaching, research, or other required activities must be included in gross income and may be subject to FICA taxes. Only reductions in excess of such deemed payments are excludable (these excess amounts are like scholarships).

Tuition reductions for graduate education can be excluded only with respect to teaching or research (not other activities) carried out by the students themselves (not other family members) at the school they are attending. Consistent with the general rule, only amounts in excess of payments for such services are excludable; reductions representing payment are included in gross income and may be subject to FICA taxes.

Veterans Education Benefits

Veterans currently receive education benefits under the Post-Vietnam Era Veterans ‘Educational Assistance Program and the Montgomery GI Bill. In addition, educational assistance is available to the spouse and children of veterans who die or are totally and permanently disabled due to a service-connected incident. While some of these benefits represent returns of contributions the veterans made (or pay reductions they agreed to) during service, the balance constitutes additional economic income. For federal income tax purposes, however, the entire amount is excludable from gross income.

Student Loans and Interest Payments

Loans as such are not income; they do not increase borrowers’ financial net worth. (While loans increase borrowers’ assets, typically their cash, such increases are offset by a liability to pay the loans back, leaving net worth the same.) As a consequence, loans as such are not subject to income taxes.

Many education loans, however, have interest subsidies that represent income to student borrowers. For example, for subsidized Stafford loans insured under the Federal Family Education Loan (FFEL) program, the federal government pays interest to lenders (or subsequent purchasers of the loans) when students are in school, during a 6-monthgrace period afterwards, and in periods of deferment. In addition, throughout the life of any FFEL loan the government may pay lenders a “special allowance” to make the return on the loans more equivalent to the market rate. The federal government makes these payments directly to the lenders, but they nonetheless represent income to the borrowers, who are relieved of what would otherwise be their financial obligation. The IRS has ruled that these interest payments are excludable from borrowers’ gross income for income tax purposes since they can be considered scholarships. There have been similar rulings for some other education loans.

Work-Study Awards

Work-study awards are a form of financial aid in which students are given jobs in order to help pay for their college education. Many awards are financed by the federal College Work-Study program, but there are also separate state and institutional programs. Students typically work for their schools, though some work for other employers. Sometimes work is integrated with the curriculum, while other times it is not. Regardless of the program, work-study awards are included in gross income for federal income tax purposes. This is the case even if earnings are used to pay tuition and required course expenses. In addition, work-study awards may be subject to FICA taxes. Employer Tuition Reimbursements. Many employers have tuition reimbursement programs for their employees. The general rule is that employer tuition reimbursements are excluded from taxpayers’ gross income if (1) the assistance is provided through an accountable plan (i.e., employees are required to substantiate reimbursements to their employer and return any excess payments) and (2) the education meets the two-part IRS tests for a deductible business expense.

This report summarizes the current rules regarding federal taxation of financial aid for students enrolled in colleges, universities, and other post secondary educational institutions. Most financial aid provides income to students, so the question arises whether they must pay federal income taxes on it. Some aid also involves employment, so students may have to pay Federal Insurance Contribution Act (FICA) taxes as well.

Taxes not filed yet?

Don’t wait until you or your Parents Financial Statement (PFS) have filed a tax return to submit the FAFSA. Financial aid will not be granted until the Federal income tax return. Instead, get your FAFSA in early using estimated income figures based on last year’s return or payroll stubs. (If your estimates are significantly higher or lower than your actual numbers, your EFC may change and your financial aid offers may be revised.)

For Your Information (FYI):
This information’s covers a variety of important tax topics related to higher education. It is intended for your educational use and not as legal or tax advice; it does not cover every facet or the full scope of this subject. We highly recommend that you consult a professional tax advisor or attorney and encourage you to visit the Internal Revenue Service Web site, where you will find the complete text of various relevant IRS publications.

IRS Publications

Reference:
http://www.policyarchive.org/handle/10207/bitstreams/358.pdf

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