CRS REPORT SUMMARIZES FEDERAL TAXATION OF FINANCIAL AID FOR STUDENTS.

                   FEDERAL TAXATION OF STUDENT AID

This report summarizes the Federal taxation of financial aid for students enrolled in colleges, universities, and other postsecondary educational institutions. Since much financial aid provides income to students, the question arises whether they must pay Federal income taxes on it. Some aid also involves employment, so students may have to pay Federal Insurance Contribution Act (FICA) taxes as well.

As a general rule, scholarships and fellowships (including grants) are not taxable if they are used for tuition and required course expenses. Tuition reductions also are not taxed. However, both types of aid are subject to income and sometimes FICA taxes to the extent they represent payment for services. Veterans' education benefits are not taxable, nor are loans; however, loan amounts that are forgiven or otherwise discharged are subject to income taxes. Work-study awards are subject to both income and sometimes FICA taxes. Employer tuition reimbursements are taxable except if they are provided under an accountable plan or, prior to January 1995, through an employer education-assistance program.

INTRODUCTION

This report summarizes the Federal taxation of six types of postsecondary student aid: scholarships and fellowships (including grants), tuition reductions, veterans' benefits, loans, work-study awards, and employer tuition reimbursements. It outlines the general rules for whether such aid is subject to Federal income and FICA taxes. ¹

The report discusses the taxation of student aid from the standpoint of students who receive it. Implications for other taxpayers -- parents, employers, private foundations, and schools -- are not addressed. This focus excludes Federal unemployment taxes, which are paid only by employers, as well as the dependency exemption for students 19 through 23 years of age, which is available only to parents. Also not discussed is the financial assistance students get from trust funds or their parents, which can involve important tax issues, or the tax-advantaged ways that families can save for college.

Federal Income Tax

Much of the aid considered in this report provides students with income in the basic sense of that term: it increases students' financial net worth. Since the Federal income tax covers "all income from whatever source derived" unless there is a specific exception, ² student aid is subject to it like other forms of income, barring such exceptions.

Generally, it is the ECONOMIC CHARACTERISTICS of student aid that determines its income tax status, not the name or outward form. The terms "scholarship" and "fellowship" in particular are frequently used loosely. Rather than being aid offered solely to help people pursue their studies or research, they sometimes involve obligations to provide service (and so are really compensation for employment) or to pay back funds (and so are really loans). Similarly, some tuition reductions represent partly employment compensation for teaching and partly an additional remission that is like a scholarship.

The SOURCE of student aid generally is irrelevant for income tax purposes. Whether financial aid originates with Federal, State, or local governments, or whether it comes from private nonprofit or for- profit organizations, typically does not affect whether it is taxable. (In contrast, the source of student employment income can be relevant for FICA taxes, as is discussed below.)

Student aid that is TAXABLE IS NOT NECESSARILY TAXED, at least not to the extent it is included in gross income on income tax returns. Individual taxpayers can offset some portion of taxable income with their personal exemption ($2,450 in 1994) and standard deduction ($3,800 in 1994 if they file a single return) or itemized deductions. For example, if students had a $2,000 taxable scholarship, they would not pay taxes on it if their other taxable income were not more than $4,250. (However, taxable income is not offset to this extent if students can be claimed as dependents by their parents or others: in this case, their personal exemption would be $0 and their standard deduction only the greater of $600 or their earned income, up to a 1994 limit of $3,800 for single returns. Taxable scholarships are considered to be earned income for purposes of this rule.) Whatever portion of a taxable scholarship is not offset by exemptions and deductions generally would be subject to a 15-percent tax rate (assuming a single return with total taxable income in 1994 of not more than $22,750).

Federal Insurance Contribution Act Taxes

Student aid that involves employment -- employer tuition reimbursements, work-study awards, and scholarships or tuition reduction that require the performance of services -- may be subject to FICA taxes. In 1994, these taxes are 6.2 percent on the first $60,600 of wages for Old Age, Survivors, and Disability Insurance and 1.45 percent on total wages for Hospital Insurance. Both employers and employees pay these rates.

If students are EMPLOYED BY THE SCHOOL they attend, the general rule is that their wages are not subject to FICA taxes, regardless of whether they are subject to Federal income taxes. ³ However, there are exceptions to this rule at public colleges and universities in several States that elect coverage for student employees under section 218(c)(5) of the Social Security Act. It should also be noted that the general rule applies only to students who are considered to be "enrolled and regularly attending classes;" it may not apply to students who take only one course or work for their school during the summer.

If students are EMPLOYED BY OTHER EMPLOYERS, the general rule is that their wages are subject to FICA taxes. However, there are exceptions to this rule for employer tuition reimbursements paid under accountable plans or, prior to January 1, 1995, through employer education assistance programs. ⁴

SCHOLARSHIPS AND FELLOWSHIPS

Scholarships and fellowships include awards based upon financial need (such as Pell grants) as well as those based upon scholastic achievement or promise (such as National Merit Scholarships). They can be excluded from taxpayers' gross income for income tax purposes provided that (1) the taxpayer is a degree candidate and (2) the amounts are used for "qualified tuition and related expenses." ⁵ These expenses include tuition and fees required for enrollment or attendance as well as fees, books, supplies, and equipment required for courses. They do not include room, board, or incidental expenses.

Scholarships and fellowships are considered used for tuition and required course expenses if they are either (1) designated for such purposes or (2) unrestricted or not designated for other purposes. Students need not trace how unrestricted funds are actually used: there is a presumption they are used for qualified expenses, up to the net amount of such expenses (that is, taking into account tuition reductions and other scholarships).

If scholarships or fellowships have a requirement for the PERFORMANCE OF SERVICES -- teaching, research, or anything else -- the portion that represents payment for such services must be included in gross income. It makes no difference whether the service is to be performed before, during, or after the scholarship or fellowship period. It also makes no difference whether the service requirement applies to all students or is necessary for attaining a degree. The portion representing payment for services may be subject to FICA taxes as well.

TUITION REDUCTIONS

Tuition reductions for employees of educational institutions can be excluded from gross income if they are (1) restricted to education below the graduate level (with one exception discussed below), (2) do not discriminate in favor of highly compensated employees, and (3) do not apply to amounts representing payment for services (sec. 117 IRC). ⁶ The last restriction is identical to the one just discussed for scholarships: amounts that represent payment for teaching, research, or other required activities must be included in gross income and may be subject to FICA taxes. Only reductions in excess of such deemed payments are excludable (these excess amounts are like scholarships).

Tuition reductions are excludable even if they are made for the employee's spouse and dependent children; they can also occur at schools other than where the employee works, provided they are remitted by the school attended, not paid by the employee's school. For example, college A could reduce the tuition of students who are children of teachers employed by college B, and neither the students nor parents would have to include the remissions in their gross income.

Tuition reductions for GRADUATE EDUCATION can be excluded only with respect to teaching or research (not other activities) carried out by the students themselves (not other family members) at the school they are attending. Consistent with the general rule, only amounts in excess of payments for such services are excludable; reductions representing payment are included in gross income and may be subject to FICA taxes.

VETERANS' EDUCATION BENEFITS

Veterans currently receive education benefits under the Post- Vietnam Era Veterans' Educational Assistance Program and the Montgomery GI Bill. In addition, educational assistance is available to the spouse and children of veterans who die or are totally and permanently disabled due to a service-connected incident. While some of these benefits represent returns of contributions the veterans made (or pay reductions they agreed to) during service, the balance constitutes additional economic income. For Federal income tax purposes, however, the entire amount is excludable from gross income. ⁷

LOANS

Loans as such are not income; they do not increase borrowers' financial net worth. (While loans increase borrowers' assets, typically their cash, such increases are offset by a liability to pay the loans back, leaving net worth the same.) As a consequence, loans as such are not subject to income taxes.

Many education loans, however, have INTEREST SUBSIDIES that represent income to student borrowers. For example, for subsidized Stafford loans insured under the Federal Family Education Loan (FFEL) program, the Federal Government pays interest to lenders (or subsequent purchasers of the loans) when students are in school, during a 6-month grace period afterwards, and in periods of deferment. In addition, throughout the life of any FFEL loan the Government may pay lenders a "special allowance" to make the return on the loans more equivalent to the market rate. The Federal Government makes these payments directly to the lenders, but they nonetheless represent income to the borrowers, who are relieved of what would otherwise be their financial obligation. The IRS has ruled that these interest payments may be excluded from borrowers' gross income for income tax purposes since they can be considered scholarships. ⁸ There have been similar rulings for some other education loans.

Moreover, when education loans are forgiven or otherwise discharged, the amounts discharged represent income to the borrowers. (Loan discharge constitutes income since liabilities are reduced without corresponding reductions in assets; thus, net worth is increased.) DISCHARGED INDEBTEDNESS must be included in taxpayers' gross income for income tax purposes unless there is a specific exception; the only ones currently allowed for education loans involve (1) cases of bankruptcy or insolvency and (2) public-source loans forgiven because borrowers subsequently work in certain occupations. ⁹ An example of the latter is Perkins loans authorized under the Higher Education Act, portions of which may be forgiven for teaching in schools in lower-income areas, performing military service, or serving in the Peace Corps or VISTA.

The Tax Reform Act of 1986 (P.L. 99-514) terminated the DEDUCTION FOR INTEREST PAYMENTS on education and other personal loans. One exception for education loans remains: taxpayers who itemize may continue to deduct interest payments on home equity loans (which can be used for any purpose) up to a debt limit of $100,000 ($50,000 for married individuals filing separately) or their net equity in the resilience, whichever is lower. ¹⁰ While few college students are homeowners, many have parents who are and who could use these loans to pay college expenses.

WORK-STUDY AWARDS

Work-study awards are a form of financial aid in which students are given jobs in order to help pay for their college education. Many awards are financed by the Federal College Work-Study program, but there are also separate State and institutional programs. Students typically work for their schools, though some work for other employers. Sometimes work is integrated with the curriculum, while other times it is not. Regardless of the program, work-study awards are included in gross income for Federal income tax purposes. This is the case even if earnings are used to pay tuition and required course expenses. In addition, work-study awards may be subject to FICA taxes.

EMPLOYER TUITION REIMBURSEMENTS

Many employers reimburse employees for courses taken at colleges and universities. Whether these reimbursements are subject to Federal income and FICA taxes generally depends on the relationship between the education and the employee's work and on the reimbursement procedures. An exception to these rules is made for certain employer education-assistance programs.

Employer tuition reimbursements are excluded from individual taxpayers' gross income for income tax purposes and are not subject to FICA taxes if they are provided under an ACCOUNTABLE PLAN that meets three requirements: ¹¹

(1) The education is job-related (it either is required or improves skills for current work) but does not enable the employee to meet minimum requirements for current work or prepare for a new career. ¹²

(2) Reimbursements are substantiated to the employer; and

(3) Employees are required to return excess payments.

If any one of these requirements is not met, tuition reimbursements must be included in employees' gross income and may be subject to FICA taxes. However, taxpayers who itemize might be able to deduct the reimbursements on their income taxes if the first requirement is met (that is, if the education is job-related, etc.). Such deductions are limited to the amount that the reimbursement plus other miscellaneous deductions exceeds 2 percent of adjusted gross income; thus they might not offset all of the reimbursement.

If tuition reimbursements are made under an EMPLOYER EDUCATION ASSISTANCE program meeting statutory requirements, up to $5,250 a year in course expenses may be excluded from employees' gross income for income tax purposes; it also is not subject to FICA taxes. ¹³ Among other things, such programs must have separate written plans, employee notification, and restrictions against discrimination in favor of highly compensated employees. The education need not be job- related and can help employees meet minimum requirements or prepare for new careers. The exclusion for employer education assistance applies only to payments made before the end of December 1994, unless Congress authorizes an extension.

² Section 61(a) of the Internal Revenue Code (IRC).

³ Section 3121(b)(10) IRC.

⁴ Internal Revenue Service regulations 1.62-2T; section 3121(a)(18) IRC.

⁵ Section 117(a) IRC.

⁶ Section 117(d) IRC.

⁷ Section 134 IRC.

⁸Rev. Rul. 75-537.

⁹ Section 61(a)(12) IRC; sections 108(a) and 108(f), respectively, IRC.

¹⁰ Section 163(h)(3)(C) IRC.

¹¹ Internal Revenue Service regulations 1.62-2T.

¹² Internal Revenue Service regulations 1.162-5.

¹³ Sections 127 and 3121(a)(18) IRC.