Many were caught off guard by a National Labor Relations Board (“NLRB”) decision last week that Northwestern University’s football players had been deemed employees by the agency and can unionize. As this USA Today article points out, there are a variety of consequences that could result from this decision (though it is far from a final ruling at this point). An interesting issue, from a tax point of view, is differences in how those scholarships could be taxed going forward.
We’ve blogged here before about differing tax treatment for scholarships, depending on what the scholarship money is used for, and whether the scholarship is received in exchange for performing services. To recap, under section 117 of the Internal Code, only “qualified scholarships” are excluded from income and not taxed. This term includes payments used for qualified tuition and related expenses required for study such as books and lab fees—but not room and board. Section 117(c) is clear that a “qualified scholarship” does not include any amount that represents payment for teaching, research or other services by the student required as a condition for receiving the scholarship.
IRS treatment of athletic scholarships under this analysis has long been perplexing to some tax practitioners and scholars. A key IRS ruling from the late 1970s held that athletic scholarships would not be considered compensatory, though this ruling relied on the fact that the scholarships couldn’t be cancelled in the event recipients could no longer participate, and the recipients were not required to participate in any other activities in lieu of participating in the sport. However, the longstanding practice of NCAA Division I schools has been to give one-year scholarships that do not have to be renewed if a player were injured or opted not to play sports anymore. While multi-year scholarships are allowed and given at some schools—including, interestingly enough, at Northwestern — this is certainly not the prevalent arrangement. However, one tax scholar thinks this decision will prompt players to bargain for four-year guaranteed scholarships.
So under longstanding practice, an athletic scholarship is not considered compensatory. However, any portion of the scholarship that is used for room and board rather than qualified tuition and expenses is taxable to the student, while the portion used for qualified tuition and expenses is not. With the recent NLRB decision, it will be interesting to see if the IRS starts to shifts its view on whether the scholarship is compensatory. Of course, the IRS is not bound to view a scholarship as compensatory because the NLRB deems the student an employee, but it is possible the agency will go that route. If the scholarship is being provided in order for the individual to play football for the school, arguably the entire amount is taxable compensation that would be taxed at ordinary income rates—with no carveout for the amount spend on qualified tuition or expenses. For many college athletes, that would likely be an unexpected and unwelcome result. However, if it means they get guaranteed four-year scholarships and a complete college education regardless of injury or other unforeseen events, it could well be worth the tradeoff.