The American Opportunity Credit (AOC) and the Lifetime Learning Credit (LLC) have been topics of discussion for their utility in helping to fund college education expenses. This article is the first of two that will cover the AOC and LLC, each of which applies in different situations and offer somewhat different challenges. This article explains how a taxpayer claiming the AOC can utilize a strategy of including tax-free scholarships in income to potentially save on overall taxes for a family; it is particularly relevant after the recent change to the “kiddie tax” under the Secure Act of 2019.
College expenses are among the largest expenses for parents funding their children’s education. Fortunately, various types of educational assistance and tax credits are available. Educational assistance includes scholarships and fellowship grants and is generally tax-free if it is used to pay for qualified educational expenses such as tuition, required fees, and course-related expenses for books, supplies, and equipment (IRC section 117). Parents who pay educational expenses for their children are also eligible to claim the American Opportunity Credit (AOC) or the Lifetime Learning Credit (LLC) to reduce their overall tax liability, though these are phased out for high-income taxpayers.
An unconventional tax saving strategy is to include tax-free educational assistance in income. Although most taxpayers prefer to exclude scholarships from their income, including some assistance in income could potentially lead to a smaller overall tax liability by making the taxpayer eligible to claim more tax credits (IRS Publication 970, Tax Benefits for Education, 2019, pp. 16, 28). Many taxpayers and tax advisors may not be aware of this strategy, and tax preparation software generally does not address it.
This article provides a step-to-step guide for CPAs and tax advisors as to whether and how to implement the strategy and determine the optimal amount of scholarship inclusion. It builds on earlier advice from Li, Chen, and Jones (Li Z., Chen C., and K. Jones, “Non-Traditional Students: Strategies for Minimizing Tax Liabilities While Avoiding Pitfalls,” The CPA Journal, September 2018, pp. 42–46; Li Z., Chen C., and K. Jones, “Navigating the Waters of Educational Assistance and Related Tax Credits,” Today’s CPA, May-June, 2019, pp. 28-32), Madison and Royalty (“Counterintuitive tax planning: Increasing Taxable Scholarship Income to Reduce Taxes,” Tax Adviser, May 2018, https://bit.ly/3m6yKBC), and Gamboa and Wheeler (Gamboa C. and Wheeler T., “Maximizing the Higher Education Credits,” Journal of Accountancy, vol. 227, no. 3, Mar. 2019, pp. 16-23, https://bit.ly/3CLE8A9, 2019). Although the strategy provides potentially significant tax savings, it is complex to implement and does not apply to all taxpayers. Whether a taxpayer should use the strategy depends upon various factors, such as a taxpayer’s qualified education expenses, scholarship amount, unearned income, and the parent’s marginal tax rate. Because a four-year undergraduate degree usually spans at least five calendar years and a taxpayer can only claim the AOC for a maximum of four years [IRC section 25A(b)(2)], parents will likely need to claim the LLC for at least one year and utilize this strategy with that credit. Applying the strategy to the LLC is the subject of Part Two.
This article is particularly pertinent due to the 2019 Setting Every Community Up for Retirement Enhancement Act (Secure Act). Before 2017, the “kiddie tax” was based on the marginal tax rate of the taxpayer’s parents. Although section 1(j) of the 2017 Tax Cuts and Jobs Act (TCJA) based the kiddie tax on the tax rates for estates and trusts, the Secure Act repealed the TCJA with respect to the kiddie tax. Specifically, the new act reversed the rule back to base the tax on the rates of the parents who claim the taxpayer as a dependent (section 501, Title V). The tax-saving strategy in this article is based on the kiddie tax rules from the Secure Act, while both Madison and Royalty (2018) and Gamboa and Wheeler (2019) are based on rules from the TCJA. Thus, eligible taxpayers can apply the up-to-date strategy from this article for tax returns from 2020 and beyond. They may also use the new provisions of the Secure Act to amend their 2018 and 2019 tax returns for tax refunds.
Education Tax Credits
Taxpayers can claim one of two educational tax credits in a given year: the AOC and the LLC. The AOC allows a taxpayer to claim up to $2,500 tax credit per year in the first four years of postsecondary studies, while the LLC allows a taxpayer to claim up to $2,000 tax credit if a student enrolls in a postsecondary educational institution. Both credits are based on a taxpayer’s qualified education expenses. For the AOC, qualified educational expenses include tuition, required fees, and course-related expenses for books, supplies, and equipment. For the LLC, qualified education expenses include tuition and required fees and exclude course-related expenses unless they are paid directly to a taxpayer’s university [IRC section 25A(f)(1)]. The AOC is the sum of 100% of the first $2,000 qualified educational expenses and 25% of the next $2,000 [IRC section 25A(b)(1)], while the LLC is 20% of the first $10,000 in qualified educational expenses [IRC section 25A(c)(1)]. Both the AOC and the LLC are subject to a phaseout for high-income taxpayers [IRC section 25A(d)]. When eligible, parents who pay for educational expenses for their child can claim the credits on their tax return and should always claim the AOC over the LLC (Beams J. and Briggs J., “Tax Planning for Parents of College Students,” Journal of Accountancy, vol. 213, no. 3, March 2012, pp. 50-54).
There can be issues when a taxpayer receives scholarships and claims either the American opportunity credit or the lifetime learning credit in the same year. The IRS does not allow “double-dipping” with respect to educational tax benefits, meaning that taxpayers cannot use the same educational expenses for more than one type of benefit (IRS Publication 970, Tax Benefits for Education, 2019, pp. 14, 25). For example, if a taxpayer uses his qualified education expense as a basis to shield his scholarship from being included in income, he cannot use the same expense to apply for the AOC.
Adjusted Qualified Education Expenses
To help taxpayers determine the amount of educational expenses they can use to calculate any tax credit, the IRS uses the concept of adjusted qualified educational expense (AQEE), which is total qualified education expense less any tax-exempt educational assistance (“Determining Qualified Education Expenses,” https://bit.ly/3xShH8s, 2019). If a taxpayer excludes his entire scholarship from income, he may have a smaller AQEE and may only be eligible to claim a smaller tax credit. The taxpayer, however, could choose to include some scholarship as taxable income in order to claim a higher credit (IRS Publication 970, Tax Benefits for Education, 2019, pp. 16, 28).
Matt is a first-year college student and his tuition, required fees, and course-related expenses are $31,000 in 2020. Matt lives at home and his parents, Scott and Mary, pay for all of his education expenses. Matt also receives a scholarship of $29,000 from his university in 2020. The scholarship can be used for tuition, required fees, course-related expenses, or room and board. Because Scott and Mary pay for Matt’s education expenses, they can claim the AOC based on their expenses for Matt. The total qualified education expenses before considering any tax-exempt scholarship are $31,000. If Matt excludes the entire scholarship from his income, then his tax-exempt scholarship is $29,000. Scott and Mary’s AQEE is thus $2,000 [31,000 – 29,000] and their eligible AOC is $2,000 [2,000 × 100%]. Mary and Scott can claim more AOC if Matt includes some scholarship into his income. For example, if Matt includes $2,000 of the scholarship in his income, his tax-exempt scholarship is $27,000 [29,000 – 2,000]. Scott and Mary’s AQEE would become $4,000 [31,000 – 27,000] and their eligible AOC becomes $2,500 [2,000 + 2,000 × 25%]. Thus, by including $2,000 in income, Matt may pay additional taxes, but Scott and Mary’s tax credit increases by $500. Whether their family as a whole can save on taxes is the focus of this article and will be explained below.
Rules for the Kiddie Tax
The kiddie tax applies to unearned income of children under 18 or full-time students qualified as dependents who are younger than 24 and have earned income less than half of their support [IRC section 1(g)(2)]. Generally, earned income includes salaries and bonuses and unearned income includes interest income, dividends, and capital gains [IRC section 911(d)(2)]. The IRS considers a student to be a dependent if his parents provide more than half of his support. Although he may still be required to file a tax return, his parents can claim him as a dependent on their tax return. While the standard deduction for a single taxpayer is $12,400 in 2020, the standard deduction for a dependent child is the greater of $1,100, or earned income plus $350, up to the standard deduction of $12,400 [Revenue Procedure 2019-44 section 3(16)].
Prior to the 2017 Tax Cuts and Jobs Act (TCJA), the calculation of the kiddie tax depended upon the tax rates of both dependent children and their parents. Specifically, unearned income above a certain threshold of a dependent child was taxed using their parent’s marginal tax rate, which is usually higher than the child’s rate. The TCJA substantially changed the kiddie tax rule, and now unearned income above the threshold is taxed using the estates and trusts tax brackets [TCJA section 1(j)]. Although the TCJA was intended to simplify the kiddie tax calculation, it increased the kiddie taxes for some dependent children because the income tax rates for trusts and estates rise much faster than regular income tax brackets. The kiddie tax under the TCJA particularly affected children who received military survivor benefits (Congressional Research Service, “The Kiddie Tax and Military Survivors’ Benefits,” https://bit.ly/3xSyYyC, 2020). The Secure Act addressed the issue and restored the kiddie tax to its pre-2017 rules for 2020 onward. Unearned income above the $2,200 threshold of a dependent child will be taxed using his parents’ marginal tax rate (Secure Act section 501, Title V, 2019). Dependent children and their parents who are affected by the kiddie tax under the TCJA in 2018 and 2019 can file amended returns under the new rule and claim refunds.
Exhibit 1 shows how to compute the kiddie tax for Examples 1 and 2, with a focus on the student. Subsequent examples will incorporate the parents’ situation and discuss the tax impacts for the family as a whole.
Calculating John’s Kiddie Tax and Total Tax in 2020
John, a college sophomore, is 19 years old. He lives at home and his parents pay for all his college expenses, which include $5,500 tuition and $500 required fees. John works part-time and earns $3,000 in 2020, while also receiving interest income of $2,100. His parents claim him as a dependent on their tax return, but John also files his own tax return; his parents’ marginal tax rate is 22%. Following the steps in Table 2, John’s gross income is $5,100 [3,000 + 2,100], and his standard deduction is $3,350 [3,000 + 350]. His total tax is $175 after considering the kiddie tax.
Assume the same facts as in Example 1, except that John’s interest income is now $7,000. His gross income is $10,000 [3,000 + 7,000]. His total tax is $1,241 after considering the kiddie tax.
Saving Taxes by Including Scholarships in Income
There are two outcomes when including scholarships in income for parents and their college students. On the one hand, when college children include scholarships in their income, their parents can potentially be eligible for a higher tax credit; on the other hand, scholarships are considered unearned income if included in income and the children may be subject to additional kiddie tax [IRS Publication 929, Tax Rules for Children and Dependents (2019, p. 8)], potentially offsetting any tax credit from the scholarship inclusion. Implementing such a strategy is complex and depends upon various factors. First, a taxpayer needs to consider how much AQEE he or she has. If the taxpayer already has enough AQEE, then he should not include any educational assistance in income. Second, the taxpayer must consider whether any additional tax would offset the potential gain from the tax credit. Third, calculating the kiddie tax is complicated. Finally, the strategy depends on which tax credit the taxpayer claims.
Determining the Amount of Scholarship Inclusion When Claiming the AOC
Exhibit 2 provides a step-by-step guide for determining how much scholarship should be included in income when claiming the AOC. The guide is based on AQEE and unearned income (UI). AQEE determines the amount of any eligible tax credit and UI determines any additional kiddie tax. Taxpayers need to keep track of both AQEE and UI to determine the optimal amount of scholarship inclusion. As more scholarship is included in income, both AQEE and UI may increase, and whether to include the next dollar of scholarship in income depends on whether such inclusion results in more tax credit or more kiddie tax liability. Because the kiddie tax calculation is complicated and depends on conditions, Exhibit 2 presents a quick guide for users to calculate the amount of scholarship inclusion that helps the taxpayer to minimize taxes.
Computing Scholarship Inclusions for the American Opportunity Credit (AOC) based on Adjusted Qualified Education Expense (AQEE) and Unearned Income (UI)
Example: Scholarship Inclusions and the AOC
Exhibit 3 and Exhibit 4 provide examples for Exhibit 2 and compare four cases with different scholarship inclusions and tax savings. All cases assume the same facts as in Example 2, except that John also receives a scholarship of $5,000 that he can use for tuition, required fees, course-related expenses, or room and board. If John excludes the entire scholarship from his income, his total tax liability is $175 (Exhibit 4) and his AQEE for the AOC is $1,000 [5,500 + 500 – 5,000], based on which his parents can already claim $1,000 of the AOC. Exhibit 3 presents John’s kiddie tax and total tax for four different amounts of scholarship inclusion.
Figuring John’s Kiddie Tax and Total Tax with Scholarship Inclusions in 2020
Scholarship Inclusions, the American Opportunity Credit, and Net Tax Savings
Exhibit 4 shows the overall tax savings for John’s family. This table ignores other factors that could affect the decision for scholarship inclusion and assumes that John’s parents have sufficient tax liability to absorb the credit. In Case 1, John includes $1,000 of the scholarship in his income and his AQEE increases to $2,000. His tax liability and his parents’ AOC increase by $208 and $1,000, respectively, resulting in a family tax savings of $792. In Cases 2 and 3, John includes $2,000 and $3,000 of his scholarship in income, and his family’s overall tax savings increases to $822 and $852, respectively. The first three cases show that the tax savings for John’s family increases as he includes more scholarship in his income. In Case 4, however, John’s AQEE after scholarship inclusion reaches $4,000, which is the maximum expense a taxpayer can use to claim the AOC. Exhibit 2 suggests that the optimal amount of scholarship inclusion is $3,000, and John should stop including any more scholarship in his income because doing so will only increase his tax liability, not his parents’ tax credit. As shown in Case 4, if John includes $1,000 more scholarship in his income, his taxes increase from $823 in Case 3 to $1,043 in Case 4, but his parents’ tax credit remains $2,500. As a result, John’s family pays $220 more tax overall in Case 4 than in Case 3.
Hidden Tax Savings
College tuition and fees are an increasingly significant expense for many parents of college students. Fortunately, scholarships and education tax credits such as the AOC can help reduce a family’s financial burden. Although most taxpayers prefer to exclude scholarships from their income, under certain circumstances, including scholarships in income could help a taxpayer claim more tax credits and lower the overall taxes of the taxpayer and his family. Unfortunately, many CPAs and tax preparers are not aware of this strategy, nor does most tax filing software consider it. CPAs and other tax advisors can inform their clients about this potentially significant tax-saving strategy.