Generally, a scholarship or fellowship grant is a cash amount paid or allowed to, or for the benefit of, an undergraduate or graduate, to aid such individual in the pursuit of study or research. (IRS Treasury Regulation 1.117-3). A scholarship or fellowship grant may also be a reduction in the amount owed by the recipient to an educational organization for tuition, room and board, or any other fee. Pell Grants, Supplemental Educational Opportunity Grants, and grants to states for state incentives are scholarships that are tax free to the extent they are used for qualifying tuition and course-related expenses during the grant period.
2.2 Qualified Scholarships (Excludable from Income)
IRS Regulations have made clear that amounts paid to an individual are scholarship or fellowship grants if “the primary purpose of the studies or research is to further the education and training of the recipient in his individual capacity,” and the payments did not represent compensation for services. (IRS Treasury Regulation 1.117-6). There is no obligation required of the student other than to remain enrolled in a degree plan and maintain qualifying requirements of the award. A “qualified scholarship” is the amount of a scholarship or fellowship grant that can be excluded from the recipient’s income and is limited to the amount used for tuition and fees, books, supplies, and equipment required for courses. These items must be required of all students in your course of instruction to be tax free. (IRS Treasury Regulation 1.117-6(c)(2)). If equipment or supplies is merely “suggested” for the course, the amounts do not qualify as qualified scholarships. The amounts representing “qualified scholarships” are not subject to employment tax withholding or reporting requirements (except for nonresident aliens – see section 9.7 on international reporting). However, no amount of a scholarship or fellowship grant received by a non-degree candidate is considered “qualified”, and thus is not excludable from wage income. See the Scholarship Quick Reference Table in Appendix A.
Any amounts received for incidental expenses or by a non-degree candidate are taxable scholarships/fellowships. Incidental expenses include room and board, travel, and expenses for equipment and other items that are not required for either enrollment or attendance, or in a course of instruction. Pursuant to IRS Notice 87-31, the payor of a taxable scholarship/fellowship is not required to withhold income tax and is not required to report the payment either to the student or the IRS. Please NOTE: This “no withholding/no reporting” rule only applies to non-compensatory scholarship/fellowship payments.
An amount represents compensation for services, and not a scholarship or fellowship grant per IRS Treasury Regulation 1.117-4, if:
- the amount represents compensation for past, present, or future employment services;
- the activity the grant payments fund is “subject to the direction or supervision of the grantor”; or
- the grant payment enables the recipient to “pursue studies or research primarily for the benefit of the grantor.”
These compensated services are considered wages for employment tax purposes and are subject to employment tax withholding and reporting requirements. Case law further establishes that whether a payment is of the nature of a scholarship or is of the nature of compensation depends on the “primary purpose” of the payment: “Was the taxpayer paid to work or paid to study?”
More specifically, with respect to research activities, an issue often arises whether the research activities constitute “services” or “independent research.” Factors that the IRS and the courts have taken into account in making this determination include:
- The extent of faculty supervision of the student’s work, including planned time schedules and required progress reports.
- The student’s ability to direct the course and direction of the research activities.
- Whether the student is able to retain any patents or copyrights resulting from his or her efforts.
- Whether the research services are directly related to the fulfillment of a contractual commitment by the university.
- Whether the student is required to work a specified number of hours a week on the research project.
- Whether the stipend payment made to the student was relatively small (generally indicative of a fellowship) or relatively large (generally indicative of compensation).
- Whether the university treated the student as an employee as evidence by withholding tax on the payments as wages and providing faculty privileges and other employee benefits.
Cases that involved these factors include Willie v. Commissioner; Gibb v. Commissioner; Littman v. Commissioner; Wrobleski v. Bingler; Bonn v. Commissioner; Zolany v. Commissioner; and Proskey v. Commissioner.
A recipient of a scholarship must include in gross income any amount which “…represents payment for teaching, research, or other services by the student required as a condition for receiving the qualified scholarship…”. Whether or not the services are required of all degree candidates is no longer a determinative factor. The disallowance from exclusion for amounts representing payment for services is true not only for cash payments, but also for amounts by which the tuition of the person performing services is reduced. Thus, tuition remission payments that represent compensation for services are not excludable. If only a portion of a scholarship or fellowship grant represents payment for services, the grantor must determine the amount of the scholarship or fellowship grant (including any reduction in tuition or related expenses) to be allocated to payment for services.
Special attention is probable by the IRS in regards to physicians and researchers who are receiving post-doctoral fellowship payments. A court case decision, Spiegelman vs. Commissioner, occurred on March 8, 1994, which interpreted this issue. The individual in question was a post-doctorate fellowship student. The court’s decision was that a post-doctorate student does not satisfy one of the conditions to be excludable — the fellowship must be used by a degree candidate. Thus, post-doctoral students’ fellowship income is includable in their W-2.
A review of the institution’s reporting practices with regard to graduate level fellowship payments should be conducted. If individuals with teaching fellowships or who are research assistants are not classified as employees (see section 1.3 Current Issues in Higher Education Audits), the following information should be reviewed:
- whether any type of services are required to be performed in conjunction with the grant;
- whether the primary purpose of the fellowship is to assist students in developing as scholars and researchers or to teach/perform research primarily for the benefit of the grantor; and
- whether fellowship recipients do the same work, for the equivalent compensation, as do employees of the institution.
The issues discussed above at Section 2.2, Section 2.3 and Section 2.4 should be used to determine the proper treatment of the fellowship payments received by graduate assistants.