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Taxability of Scholarship Awards

Question:

A church funds a yearly scholarship for a needy student. Will payment of the funds directly to the college help avoid taxation to the student?

Answer:

Any scholarship funds, whether paid to the student or directly to the college, generally are not taxable, as long as they do not represent disguised compensation. For example, a scholarship awarded to an "unpaid intern" in lieu of cash compensation will not be tax-free.

IRS Publication 525: "A candidate for a degree can exclude amounts received as a qualified scholarship or fellowship. A qualified scholarship or fellowship is any amount you receive that is for tuition and fees required to enroll at or attend an eligible educational institution, or
course-related expenses, such as fees, books, and equipment that are required for courses at the eligible educational institution. These items must be required of all students in your course of instruction. Amounts used for room and board do not qualify for the exclusion."

Scholarship funds will, however, reduce the amount of qualified education expenses that can be used to calculate education-related tax benefits. Essentially, the more scholarship funds that the student takes advantage of, the less his or her benefit for education-related expenses will be. 

Additionally, if total scholarships exceed qualified education expenses, the excess can be taxable as income. IRS Publication 570 provides additional guidelines regarding taxation of scholarship funds: "A scholarship or fellowship is tax free only to the extent:
  • It does not exceed your expenses
  • It is not designated or earmarked for other purposes (such as room and board)
  • It does not represent payment for teaching, research, or other services required as a condition for receiving the scholarship"

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