For many students, scholarships can be make-or-break items in terms of being able to pay for college. And, in many circumstances, scholarships will not be considered taxable income to the student, which helps the money go further. However, attaching requirements for students to perform services sometimes can turn a non-taxable scholarship into taxable income, and scholarship providers should be mindful of what factors might trigger this. A recent IRS ruling sheds some light on how certain service requirements can be built into a scholarship without triggering taxation.
Under section 117 of the Tax Code, only “qualified scholarships” are excluded from income. 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.
So if a student receives a scholarship from a university, but is required to teach a university class as a condition of receiving it, all or part of the scholarship will be included in income as compensation. Importantly, this limitation can snag some scholarships where the services aren’t required to be performed for the scholarship provider. For example, if a provider can direct where a student is to perform services (even if the services won’t be for the provider), the scholarship is likely taxable. See, e.g., Rev. Rul. 73-256.
Some Requirements OK
In a recent ruling, the IRS held that a scholarship program that required recipients to perform a certain level of community service did not give rise to taxable income. The program allowed recipients to perform 50 percent of the required amount in nearly any volunteer position of the student’s choosing, and the remaining 50 percent had to be satisfied through one of several public service projects organized by the provider. Of note is that the scholarship provider partnered with other charities in organizing these projects, and the other charities received the benefit of the volunteer services and were responsible for supervising the student volunteers. The IRS emphasized that:
- the students had choice in selecting where to volunteer;
- control and supervision over the student volunteers was not exercised by the scholarship provider; and
- any benefit flowing back to the provider was insubstantial and inconsequential, as the program was primarily designed to achieve social and educational objectives.
This ruling is consistent with an earlier ruling (Private Letter Ruling 9526020), involving law school students, who were required to work after graduation in a public interest setting for a number of years in order to receive scholarships. In that ruling, the IRS again emphasized the fact that the students had choice in where to work, within certain income parameters, and that the program was designed to further public purposes rather than the private interests of the scholarship provider.
For providers, these rulings underscore the importance of carefully evaluating any service requirements that are built in to scholarships—because for students, the question of taxability can make all the difference.
Leaffer Law Group advises on many different aspects of scholarships, and attorneys Karen Leaffer and Becky Seidel regularly present at the National Scholarship Providers Association annual conference. Karen Leaffer’s 2013 presentation focuses on “The Perils of Donor Participation in Scholarship Funds.”