Office of General Counsel

Federal Taxation of Scholarship and Fellowship Grants*

 

The federal taxation of scholarship and fellowship grants must be approached from two totally different perspectives -- the tax impact on the individual who receives the scholarship/ fellowship grant, and the tax obligations imposed on the educational institution that makes the grant. The recipient is concerned with whether the grant represents taxable income, while the institution is interested in knowing what its tax withholding and/or tax reporting obligations may be when it makes the grant.

 

Taxation of Recipients of Scholarship/Fellowship Grants

Withholding and Reporting Obligations Imposed on University

Source

 

Taxation of Recipients of Scholarship/Fellowship Grants

Since 1954, the Internal Revenue Code has contained a provision that permits the recipient of a scholarship or fellowship grant to exclude some or all of the grant from gross income. This provision is set forth in section 117 of the Code and, at least until 1986, generally permitted the entire amount of most scholarship and fellowship grants to be excluded from the recipient's gross income. In 1986, however, Congress drastically limited section 117 by restricting the exclusion to cover only those portions of a scholarship/fellowship grant that Congress believed were directly related to education, such as tuition, fees, and books. Those other elements of typical scholarship/fellowship grants, such as room, board, and travel, were considered by Congress to be non-educational and therefore ineligible for the section 117 exclusion.

As a result of the 1986 changes to section 117, the current rule relating to the taxation of scholarship/fellowship grants is that the grant must be broken into its different component payments (tuition, fees, books, room/board, travel, etc), with each component payment analyzed separately. A payment will qualify for the section 117 exclusion only if:

  1. The payment is a "qualified scholarship;"
  2. The recipient is a "candidate for a degree;" and
  3. The award is for the purpose of conducting study or research at an "educational organization."

Each of these terms requires further explanation.

  1. The "Qualified Scholarship" Requirement -- An amount will be treated as a "qualified scholarship" if it is a payment for either (i) tuition and fees required for enrollment or attendance at the educational institution, or (ii) fees, books, supplies or equipment required for courses of instruction. Note that the fees, books, and other non-tuition items must be "required" for either enrollment or a course of instruction. Voluntary fees and "suggested" books and supplies do not qualify.
  2. The "Candidate for a Degree" Requirement -- The definition of a "candidate for a degree" is broader than one might initially expect. It includes, of course, those individuals who are actually enrolled in a degree-seeking program, but also covers enrolled students who are not actually seeking a degree, as long as the educational institution that the person attends offers degrees and is properly accredited. For example, an individual who receives a one year fellowship to study at ASU is a "candidate for a degree" for purposes of section 117 even though the individual will not receive a degree at the end of the fellowship because ASU is an accredited educational institution that offers degrees.
  3. The "Educational Organization" Requirement -- Finally, the "educational organization" test is easily met in most instances because it simply requires that the institution have a faculty, a curriculum, and a regularly enrolled body of students.

If a payment meets all three of these tests, it is excludable from the recipient's gross income; however, if any part of a scholarship/fellowship payment fails any one of these tests, the payment is taxable to the recipient. The most common taxable elements of a scholarship/ fellowship are room, board, and travel payments because they do not meet the "qualified scholarship" test.

Withholding and Reporting Obligations Imposed on University

Because of the changes made by Congress in 1986 to the section 117 rules, a significant number of previously excluded scholarship/fellowship grants became taxable to the recipients, and colleges and universities making these newly taxable scholarship/fellowship grants asked the Internal Revenue Service a natural and sensible question: Do we now have to start withholding income tax and filing information returns on the taxable portions of the scholarship/fellowship grants that we make? In 1987, the IRS issued a ruling holding that an institution is not required to either withhold income tax or file any information returns with respect to taxable scholarship/ fellowship grants. Thus, even though the individual may receive taxable scholarship/fellowship income, the institution making the payment is not required to withhold any tax or file any reports with the IRS with respect to the taxable grant.

This "no withholding/no reporting" rule, however, is subject to two important caveats.

First, the scholarship/fellowship recipient must be either a U.S. citizen or a U.S. resident alien for tax purposes. If the recipient is a nonresident alien, income tax withholding is required at a rate of 14%, unless the grant is exempt under a tax treaty between the U.S. and the recipient's home country. And, if the scholarship/fellowship payment is made to a nonresident alien, the taxable portion of the grant (generally, amounts paid for room, board, and travel) must be reported to both the IRS and the individual on Forms 1042 and 1042-S. The IRS, however, does not require Form 1042/1042-S reporting with respect to the nontaxable portion of the scholarship/fellowship grant, which generally consists of amounts paid for tuition, fees, and books.

Secondly, the payment that the institution makes to the individual must be a true "scholarship" or "fellowship" and not disguised compensation for services rendered. For example, a fellowship grant made to a graduate student may require that, as a condition of receiving the grant, the individual must work in the laboratory or teach for a specified period during a semester. To the extent that the IRS determines that some of a scholarship/fellowship grant is actually compensation for teaching, research, or other services, it will recharacterize that portion of the grant as normal employee compensation on which income tax must be withheld and normal tax reporting must be made.

But if the scholarship/fellowship grant is made to a U.S. citizen or U.S. resident alien and is not disguised compensation for services rendered, the institution is not required to withhold any tax or file any reports with respect to any taxable scholarship/fellowship grants it may make.

Source

*Bertrand M. Harding, Jr.

This article was contributed to the ASU General Counsel Briefing Paper Series by Bertrand M. Harding, Jr., an attorney in Washington, D.C., specializing in the college and university tax area. Mr. Harding currently represents ASU on certain federal tax issues.

For more information on this and other college and university tax matters, see The Tax Law of Colleges and Universities, published by John Wiley & Sons (2001).

 


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