Some colleges and universities, eager to save their student workers from tax liability and avoid additional payroll charges, may compensate student workers by providing them “scholarships” or “account credits” that directly reduce charges for tuition, books, fees, and room and board. While well-intentioned, these practices may be rooted in a misunderstanding of the federal tax exemption for “qualified scholarships” and risk significant unpaid tax liability for students and penalties for the institution itself. Scholarships paid to students for performing work are generally taxable and may even constitute hidden wages that should be reported on W-2s.
As a starting point, the federal tax code defines income to include “all income from whatever source derived.” 26 U.S.C. § 61. Certain types of income are “exempt” from taxation, including “qualified scholarships.” 26 U.S.C. § 117(a). Generally speaking, a “qualified scholarship” consists of amounts received by a degree candidate to be used for the payment of tuition and related expenses, such as fees, books, and supplies—but not room and board. 26 U.S.C. § 117(b). To the extent the value of the scholarship exceeds the cost of tuition and related expenses, the difference is treated as taxable income. Further, the tax code specifically excludes from the definition of a “qualified scholarship” amounts that “represent payment for teaching, research, or other services by the student required as a condition for receiving the qualified scholarship or qualified tuition reduction.” 26 U.S.C. § 117(c)(1).
Thus, for example, if a student receives a $1,000 scholarship but, as a condition to receiving that scholarship, the student must work four hours a week in the cafeteria for the entire semester, the scholarship is not a “qualified scholarship” and is taxable. In addition, depending on the circumstances, such a scholarship could meet the tax code’s definition of “wages”—that is, “all remuneration. . . for services performed by an employee for his employer,” which would require the payment to be reported on a W-2 and appropriate withholdings made. The failure to properly issue a W-2 and withhold taxes can result in significant penalties for an institution. See 26 U.S.C. 6656(a), 6721, and 6722.
As with many aspects of tax law, there are exceptions. For example, the IRS has recognized an exception that compensation paid to students under a student work program that is an integral part of a college’s scholastic program is not taxable. But this “work college” exemption is narrow, and applies when the college mandates that students perform the work as part of an overall scholastic program tied to the institution’s educational philosophy. Most institutions that employ only a fraction of their students as workers will not fall within the exception.
What This Means to You
Colleges and universities that award scholarships or similar payments to students in exchange for work should familiarize themselves with the pertinent provisions of the tax code governing the taxability of such payments. The IRS’s publication on the taxability of scholarships, fellowships, grants, and tuition reductions is a useful starting point. If the payments are taxable, they must be appropriately reported and handled as wages, if necessary. Institutional leaders who are unsure of the appropriate tax treatment of their scholarships should consult an accountant or attorney for advice.