Everyone knows what a scholarship is. Free, no-strings-attached money to help a student pay for their higher education. Right? Usually. But not always.A (very) brief history of the tax treatment of scholarships
The tax status of scholarships was first codified in 1954, and until 1980 it was exceedingly simple: for students pursuing a degree, all scholarships, fellowships and grants were tax-free, no matter what the funding was used for.
The first major change to this system came in 1980, with the Tax Treatment Extension Act. This amendment stated that scholarships, grants or fellowships could be taxed if they could be considered “fees for services.” This can include... “[money] received as payments for teaching, research or other services required as a condition for receiving the scholarship or fellowship grant.” Exceptions were later added for teaching and research assistantships and for certain federal student aid programs, but this represented the first time any income related to scholarships was regarded as taxable.
The 1986 Tax Reform Act added significantly more potential taxation to scholarship and grant funds. For the first time, the new law specified that portions of scholarship aid used for living, travel or research expenses would be treated as taxable income. While later amendments eased some of the tax burden (especially for graduate student teachers), this potentially costly law remains on the books today.
Finally, current law also states that scholarships for non-degree-candidates are taxable.What is tax-free?
A scholarship, a fellowship grant or other grant may be partly or entirely tax free if you meet the following conditions:
• You’re a candidate for a degree at an educational institution that maintains a regular faculty and curriculum and normally has a regularly enrolled body of students in attendance at the place where it carries on its educational activities; and
• The amounts you receive are used to pay for tuition and fees required for enrollment or attendance at the educational institution, or for fees, books, supplies and equipment required for courses at the educational institution.What is taxable?
You must include in taxable income:
• Amounts used for incidental expenses, such as room and board, travel and optional equipment.
• Amounts received as payments for teaching, research or other services required as a condition for receiving the scholarship or fellowship grant. However, you don’t need to include in gross income any amounts you receive for services that are required by the National Health Service Corps Scholarship Program or the Armed Forces Health Professions Scholarship and Financial Assistance Program.
For a complete plain English explanation of the rules refer to IRS publication 970 – Tax Benefits for Education