Tax Exemptions For Scholarships And Fellowships
Section 117 of the Internal Revenue Code taxes scholarship and fellowship grants for items that are not qualified (nontaxable). Although scholarship and fellowship grants for which no services are required are not reportable to US citizens and resident aliens, the recipient may nevertheless be subject to income taxes on the grant. Taxable scholarship and fellowship grants paid to or on behalf of nonresident alien recipients, however, are subject to withholding and reporting unless a tax law or treaty exception applies.
Qualified vs. Nonqualified Grants
Qualified (nontaxable) grants are for tuition and required fees for enrollment, along with books, fees, supplies, and equipment required of all participants in a course of study provided the recipient is a “candidate for a degree at an educational organization described in section 170(b)(1)(A)(ii). ”
IRS Publication 970, Tax Benefits for Education, provides a liberal definition of the term “candidate for a degree.” Post-doctoral students are never considered candidates for a degree, and are, therefore, not eligible to claim qualified expenses – their total fellowships are always nonqualified even if they are enrolled in classes.
Publication 970 also provides a helpful chart, “Tax Treatment of Scholarship and Fellowship Payments,” which identifies taxable and nontaxable payments. Payments which would be nontaxable if the recipient were a candidate for a degree are taxable if the recipient is not a candidate for a degree. Other types of taxable payments listed include room and board, research, and travel. The list is not all-inclusive.
Taxation of Grants
Although taxable grants of U.S. citizens and resident aliens are not subject to reporting, they are, nevertheless, taxable and includable in gross income. The recipients must record them on their Form 1040 under wages with “SCH” on the dotted line unless their total worldwide income is under the filing threshold and they are therefore not required to file.
The taxation of scholarship and fellowship grants of nonresident aliens depends on the immigration status of the recipient. Taxable grants of recipients in F, J, M, or Q status, who are deemed by the Code to be engaged in a U.S. trade or business, are taxed at graduated rates after deductions. Nonresident recipients in any other immigration category are subject to 30 percent withholding on the gross amount. All taxable grants of nonresidents must be reported on Form 1042-S under Income Code 15. There is no de minimis rule. (Qualified grants are not required to be reported on Form 1042-S.)
Withholding on Grants
Generally, payments to nonresidents are subject to 30 percent withholding. A reduced rate of 14 percent applies to F, J, M, or Q candidates for a degree at an educational organization described in section 170(b)(1)(A)(ii). A nonqualified scholarship grantee who does not meet these requirements is subject to 30 percent withholding unless the grantor is one of the organizations described in Section 1441(b)(2), such as 501(c)(3) organizations, foreign governments, certain international organizations, and the U.S. government or political subdivision or agency thereof.
Withholding applies only to a grant from a U.S. grantor for study, training, or research in the United States. Grants for such activities performed outside the United States are foreign-source income, not subject to tax when received by a nonresident. If the grantor is not a U.S. entity, the grant is foreign-source, and therefore not subject to U.S. tax for nonresidents, regardless of the location of the activity. Also, U.S.-source USAID per diems for subsistence are not subject to withholding under the tax law but are nevertheless subject to tax.
Payers may apply wage withholding to taxable grants of recipients in F, J, M, or Q status. (Amounts remain reportable on Form 1042-S, not Form W-2, the income of which also determines benefits such as pensions not available to grant recipients.) Few payers make this election because of concern that tax rates computed are not considered valid Form 1042-S rates.
The withholding on taxable grants can be reduced or eliminated through withholding allowances. Withholding allowances only apply to nonresidents in F, J, M, or Q status. No U.S. TIN is required for the withholding allowance reductions (unless multiple allowances are claimed), but one will be required for tax return purposes.
Grant recipients not claiming the personal exemption on an employment W-4 may use the personal exemption amount ($3,650 for 2009) as a withholding allowance to offset their taxable grant. They are not required to prorate the amount although that would be advisable if they could have employment income later in the year. No paperwork is required (other than proof that the recipient is in F, J, M, or Q status) except for recipients allowed to claim additional personal exemption amounts, such as residents of Canada and Mexico, among others.
The withholding allowance cannot exceed the taxable grant being reported. If it is less, the tax is applied to the grant after deducting the withholding allowance. The amounts must all be reported on Form 1042-S.
If the taxable grant consists of travel expenses totaling more than the personal exemption amount, and the recipient will be in the United States for 12 months or less, Rev. Proc. 88-24 provides steps which also appear in IRS Publication 515, page 21 (tax year 2008 version), under “Alternate Withholding Procedure,” which can be used to further reduce the withholdable amount down to zero in most cases.
These procedures provide a means of exempting temporarily away-from-home business expenses from tax, similar to the accountable plan rules. (Accountable plan exclusions only apply to travel reimbursements attributable to personal services.) For tax return purposes, taxpayers have historically claimed these travel expenses on Form 2106-EZ or 2106 (since there is no other form available) and brought them forward to Schedule A of Form 1040NR as itemized deductions.
Although the grantor will most likely not require receipts for disbursement purposes, the grantee must be able to defend any deductions to the IRS by keeping adequate records to establish the amounts claimed, the time and place of the expenditure, and the business purpose of the expense as it relates to the conduct of the taxpayer’s trade or business in the U.S.
Payers need to provide recipients with a breakdown of expenses so that recipients can prepare their tax returns correctly.
Taxable scholarship and fellowship grants must be recorded on the recipient’s tax return – Form 1040 for US citizens and resident aliens or Form 1040NR and Form 1040NR-EZ for nonresident aliens. The withholding tax on nonqualified (taxable) scholarship and fellowship grants may be reduced or eliminated if a taxable grant may be offset by a withholding allowance (deduction). Recipients of taxable grants should consider making estimated federal and state tax payments on taxable grants to the extent that the grant is not subject to withholding.
Paula N. Singer, Esq. chairman of Windstar Technologies, Inc. and partner in the tax law firm, Vacovec, Mayotte & Singer, Newton, MA, has over 25 years of experience providing advice and compliance services to employers on cross-border employment matters. She is also the editor of "US Tax Compliance For Immigrants And Employers: The Lawyer's Complete Guide". To learn more, see: http://www.ilw.com/books/tax.shtm. For more information, visit www.windstar.com. For additional information, call 1-800-259-6398 or email: firstname.lastname@example.org.
Terri Crowl joined the Windstar staff on March 2007 as Senior Product Support Analyst responsible for assisting clients with the Tax Navigator product including treaty analysis, processing procedures, system function analysis, and product and tax issues training. Terri worked for Windstar prior to 2007, assisting at our training sessions and providing support to Tax Navigator clients. She is also a frequent contributor to the Windstarusers listserv.
The opinions expressed in this article do not necessarily reflect the opinion of ILW.COM.