After a regional office of the National Labor Relations Board (NLRB) ruled earlier this year that college football players at Northwestern should be treated as employees (13-RC-121359, 3/26/14), there was much speculation concerning the potential tax implications. For instance, based on the ruling, college athletic scholarships might be subject to federal income tax. But the IRS quickly nipped this notion in the bud.
In response to a Congressional inquiry, the IRS issued a new information letter stating that the existing provisions of the tax code will continue to apply to scholarships, irrespective of the NLRB ruling (IRS IL Number: 2014-0016, 6/27/14). Case closed.
Yet the tax rules remain somewhat murky to many parents of athletes and other scholarship recipients. Despite a common misconception, not all scholarships are tax-free, while others may be only partially tax-free. Here's a brief review.
The main tax law provision in question is Section 117. Under this section, a scholarship or fellowship is exempt from tax only if you are a candidate for a degree at a qualified educational institution and only to the extent of your expenses. The scholarship can't be earmarked specifically for room and board nor may it represent payment for teaching, research, or other services required as a condition for receiving the scholarship (other than exceptions for the national health services and the armed forces).
When is a student considered to be a candidate for a degree? He or she must meet one of the following conditions:
- Attend a primary or secondary school or is pursuing a degree at a college or university.
- Attend an accredited educational institution that provides a program acceptable for full credit toward a bachelor's or higher degree, or offers a program of training preparing students for gainful employment in a recognized occupation.
If this requirement isn't met, the scholarship is fully taxable.
What types of education expenses qualify for tax-free treatment? The IRS says the exclusion applies to:
- Tuition and fees required to enroll at or attend an eligible educational institution.
- Course-related expenses, such as fees, books, supplies, and equipment that are required for the courses at the eligible educational institution. These items must be required of all students in the course of instruction.
Conversely, qualified education expenses do not include the cost of:
- Room and board.
- Clerical help.
- Equipment and other expenses not required for enrollment in or attendance at an eligible educational institution.
This leads back to the perception that scholarships—in particular those handed out to college athletes—are completely exempt from tax. Frequently, they are only partially tax-free.
Example: Suppose a football player gets a free ride at State University. The annual tuition and fees are $10,000 while room and board is $2,500. In this case, the student owes tax on $2,500 a year.
Taxable scholarship income is reported on the student's 1040 (or 1040A or 1040EZ). Keep your clients informed so they aren't blindsided come tax return time. More information is available in Publication 970, Tax Benefits for Education.