Every year, millions of students receive scholarships, fellowships, and tuition reductions. Many assume these amounts are tax-free. That’s true – up to a point. Section 117 excludes qualified scholarships from gross income, but the rules are filled with traps for the unwary students and their families.
The Basic Rule: Section 117(a) and (b)
Section 117(a) provides that “gross income does not include any amount received as a qualified scholarship by an individual who is a candidate for a degree at an educational organization described in section 170(b)(1)(A)(ii).” Section 117(b)(1) defines a “qualified scholarship” as any amount received as a scholarship or fellowship grant that is used for “qualified tuition and related expenses.”
Those expenses are defined in Section 117(b)(2) as:
- Tuition and fees required for enrollment or attendance
- Fees, books, supplies, and equipment required for courses
Notably, room and board are excluded. Scholarship money used for housing and meals is taxable to the student.
The Candidate for a Degree Requirement
The exclusion applies only to degree candidates. Section 117(c) provides that scholarships to non-degree candidates (e.g., post-doctoral researchers not enrolled in a degree program) are fully taxable, except for amounts used for tuition and fees – but even then, the exclusion is limited and subject to complex rules.
The Problem with “No Strings Attached” Scholarships
What if a student wins a scholarship that is not restricted to tuition and fees? The student can choose to apply the scholarship to qualified expenses and exclude that portion. The remainder – if any – is taxable. But if the scholarship explicitly says it can be used only for room and board, the entire amount is taxable because it fails the “qualified scholarship” definition.
In *Prop. Reg. Section 1.117-6(c)(1)*, the IRS provides that a scholarship includes an amount received even if the student has discretion over how to spend it. The student must actually use the funds for qualified expenses to exclude them. If the student receives a $10,000 unrestricted scholarship and spends $8,000 on tuition and books and $2,000 on pizza, only $8,000 is excludable.
Tuition Reduction for Employees and Their Families
Section 117(d) provides a special rule for tuition reduction for employees of educational institutions. An employee of a university can exclude the value of tuition reduction for undergraduate education for themselves, their spouse, or their dependent children. This exclusion applies even if the employee’s child is not a candidate for a degree (though the educational institution must be a degree-granting institution).
The exclusion also applies to graduate education if the employee is a graduate student engaged in teaching or research activities.
Critically, the tuition reduction must be provided by the educational institution that employs the employee – not by a different institution. And the exclusion does not apply to tuition reduction that represents payment for services (e.g., a teaching assistant’s tuition waiver may be compensation under Section 83, not a scholarship).
The Scholarship Double-Dip Problem
A student can receive both a tax-free scholarship and an education-related tax credit (the American Opportunity Credit or Lifetime Learning Credit under Section 25A), but not for the same expenses. Section 25A(g)(2) requires that qualified tuition and related expenses be reduced by tax-free scholarships before applying the credit. This prevents double-dipping but can be strategically managed by allocating scholarship funds to room and board (taxable) and claiming the credit for tuition.
What About Athletic Scholarships?
Athletic scholarships are fully excludable under Section 117 if they meet the qualified scholarship requirements. The NCAA’s rules (limiting scholarships to tuition, fees, room, board, and books) actually align with the tax rules, but only tuition, fees, books, and supplies are excludable – room and board remain taxable. Many student-athletes are surprised to receive Form W-2 or 1099 for the taxable portion.
The Professor’s Kid – A Classic Example
Consider the professor’s child who receives a 50% tuition reduction because of the parent’s employment. Under Section 117(d), that reduction is excludable from the child’s gross income. But what if the child also qualifies for a merit scholarship from the university? The combined benefit cannot exceed tuition – excess may be refunded to the student and may be taxable.
In the textbook example, a student with a 50% tuition reduction plus a $14,000 scholarship might have tuition fully covered plus a $4,000 surplus. That surplus is taxable income to the student if refunded in cash. There is no exclusion for “profit” from scholarships.
The IRS’s Lenient Stance on Fellowship Stipends
For graduate students, the line between scholarship (excludable) and compensation (taxable) can blur. Research assistantships often involve significant services for the university. The IRS has historically taken a lenient stance, allowing exclusion for amounts that are primarily for the student’s benefit, not for services required of all students.
*Rev. Rul. 2005-11*, 2005-1 C.B. 618, held that a medical resident’s stipend is compensation, not a scholarship, because the residency program’s primary purpose is to provide services to the hospital. The resident was required to work long hours under supervision, indistinguishable from an employee. This ruling has been applied broadly to post-graduate training programs.
Planning for Scholarship Taxation
Students and parents should document the allocation of scholarship funds to qualified expenses. Keeping receipts for books, supplies, and equipment (including computers required for enrollment) can maximize the exclusion. For students with generous scholarships exceeding tuition and fees, consider whether to decline the excess or expect to pay tax on it.
The Section 117 exclusion is generous but not unlimited. Undergraduate students rarely exceed the cost of attendance with tax-free scholarships; graduate students with large stipends often find part of their funding taxable. Understanding the rules – and the difference between a “scholarship” and “compensation for services” – can save thousands in unexpected tax liability.
Disclaimer: This article provides general information for educational purposes only and does not constitute legal advice. Tax laws, judicial interpretations, and IRS guidance are subject to change at any time through legislation, regulation, or court decision. Readers should consult Alan Goldstein & Associates for advice regarding their specific factual situations.
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