When institutions begin a new academic year, one challenge that the business office faces is assisting students with tax issues surrounding attendance. It is helpful for university employees to understand the reporting issues and how institutional tax reporting impacts parents’ and students’ personal tax returns, and what key exclusions from income may be available for employees attending the institution.
Understanding Available Credits & Tax Reporting
University employees may find themselves responding to questions from parents and students regarding which expenses are eligible for credits and how the student Form 1098-T impacts the related personal tax return(s).
In general, institutions should advise that scholarships used for tuition and related expenses are nontaxable to the student, while scholarships for room and board, or which exceed the student’s tuition and related expenses, are taxable. Expenses paid out of pocket for qualified tuition and related expenses are potentially eligible for tax credits when filing the student’s or parent’s personal tax return. Expenses that are considered qualified tuition and related expenses include the following:
- Books and equipment
- Course/program fees
- Distance learning fees
- Enrollment confirmation fees
- Exam fees, IT fees, records fees, and student athletics or student association fees
- Other mandatory fees without personal benefit
Expenses that are not qualified expenses include housing costs, dining/meal plan payments, parking permits, transportation costs, and other fines such as library or parking fines.
Students who do not have scholarships that cover the full cost of their qualified tuition and related expenses should consider whether the American Opportunity Tax Credit or Lifetime Learning Credit is available.
The American Opportunity Tax Credit is a partially refundable tax credit that allows a taxpayer to claim up to $2,500 spent on tuition or other qualified expenses for undergraduate education. As a result, the credit is available for a maximum of four years. The credit is subject to a phaseout based on the taxpayer’s modified adjusted gross income and is refundable up to $1,000.
The Lifetime Learning Credit allows a taxpayer to claim up to $2,000 spent on qualified expenses and tuition for undergraduate, graduate, or non-degree/vocational students. There is no limit on the number of years this credit can be claimed, but it cannot be claimed in the same year that the taxpayer claims the American Opportunity Tax Credit. The Lifetime Learning Credit also is subject to phaseout; however, it is not refundable.
A common area of confusion related to these credits is when expenses paid are eligible for the credits. Form 1098-T reports the total payments received by the institution for qualified tuition and related expenses in Box 1 and all scholarships and grants paid to the institution in Box 5. To the extent that Box 1 exceeds Box 5, the student or parents likely have expenses that were paid personally and are therefore eligible for one of the available education tax credits. If the full cost of the student’s qualified tuition and related expenses is covered by scholarships and grants, there would likely be limited opportunity to claim a tax credit.
Understanding the availability of these credits and how Form 1098-T reporting may or may not directly indicate the potential expenses available for a credit gives the institution the opportunity to guide students and parents in the right direction when it comes to filing their personal tax returns.
While scholarships are nontaxable to students to the extent that they are used to pay for qualified expenses, there may be situations where scholarships are not tax-free. Institutions should be aware of some common triggers that cause financial aid to become taxable income.
The financial hardships created by unpaid internships have been identified as a barrier for some students to secure opportunities for hands-on learning, network building, and gaining practical experience in their field. Institutions and donors looking for ways to equalize access to these opportunities have identified scholarships connected to unpaid internships as a potential solution. These efforts may result in scholarship dollars that are used for student living expenses and exceed the student’s qualified tuition and related expenses, resulting in taxable scholarships. Institutions should be aware of the potential for these payments to result in taxable income for the students and help ensure that students are informed prior to accepting the funds.
International students who receive nontaxable scholarships generally do not trigger any tax reporting requirements for the institution. However, when financial aid funds are used for student living expenses such as room and board, the funds are taxable. Institutions that have international students with taxable scholarships may have additional tax reporting requirements, including Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding. This form is required to be filed by the institution, although taxability of the income may vary depending on if the U.S. has a tax treaty in place with the student’s country of citizenship. The student may be required to file a Form 1040-NR to report U.S. taxable income in some situations as well.
Employee Educational Exclusions
One of the benefits that is available to employees of higher education institutions is the ability to receive tax-free educational assistance for employees and dependents. Under IRC Section 117(d) and §127, institutions can offer significant educational benefits to employees and their family members with no tax impact.
The §117 exclusion applies to employees, their spouses, and their dependent children. This provision allows nonprofit universities to give their employees and their dependents tuition reductions that are excluded from the employee’s taxable income. The §117(d) exclusion applies to undergraduate tuition, and if the institution chooses to offer this benefit it must not be discriminatory—all employees must be able to utilize the benefit. Graduate students who are engaged in teaching and research also are eligible for the §117(d) exclusion, allowing institutions to help graduate students with nontaxable tuition while those students are serving as teaching or research assistants.
Section 127 allows employers to provide tax-free educational assistance of up to $5,250 per year to employees. This tax-free benefit applies to employees only, excluding spouses and dependents, but it is available for both graduate and undergraduate tuition, as well as student loan repayment assistance under the 2020 CARES Act.
To allow the tuition assistance to qualify as a tax-free benefit, the employer must have a written §127 plan in place, which must not be discriminatory in favor of any class of employee. The plan is limited to offering educational assistance, and employees must be notified that the plan is available. Eligible employees include current, retired, furloughed, and disabled employees.
Tuition excluded under §117(d) and §127 is not required to be reported on the employee Form W-2. Any tuition assistance received by an employee in excess of the §127 $5,250 exclusion amount is a taxable benefit reported on the employee’s W-2.
Finance and student aid office staff frequently wear many hats, and impromptu tax advisor to students and parents looking for information and clarification may be one of them. While the final answer should always be to direct them to their personal tax advisor, understanding the general issues at play can help the institution provide helpful information so the student experience remains positive.
If you have any questions or need assistance, please reach out to a professional at FORVIS.