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  • IRS Determines that Certain Scholarship Funds are Not “Taxable Payments”

    It is scholarship award season and students throughout the nation are receiving college acceptance packages informing them that they have received financial aid to help cover tuition costs. It is undeniable that many of these students will turn to scholarships to help reduce the significant and skyrocketing costs of obtaining a higher-education degree. The federal government generally does not currently require students to pay taxes on such scholarships; however, the scope of this tax exemption has recently raised some concerns.

    The Internal Revenue Code (“IRC”) states that taxable “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.”[1] A qualified scholarship is “any amount received by an individual as a scholarship or fellowship grant to the extent the individual establishes that, in accordance with the conditions of the grant, such amount was used for qualified tuition and related expenses.”[2] However, this “qualified scholarship exemption” under IRC § 117(a) does not apply towards “any amount received which represents payment for teaching, research, or other services by the student required as a condition for receiving the qualified scholarship or qualified tuition reduction.”[3] It is this limitation on § 117(a) that has raised some concerns, and the IRS recently provided guidance as to how this limitation applies.

    In a Private Letter Ruling (“PLR”),[4] the Taxpayer was an IRC § 501(c)(3)[5] entity who sponsored a program that would provide college funds to high school students that satisfied certain community service and academic performance standards. While 50% of the community service requirement could be achieved by the student volunteering her own time individually, the remaining 50% were to be fulfilled by the student participating in public service projects organized and sponsored by a third party organization (not the Taxpayer). For each event that the student participated in, the student would receive a certain amount of electronic scholarship credits. These credits were then paid directly from the Taxpayer to the institution where the student was enrolled.

    The issue in this PLR was whether any portion of the scholarship money received by the student participants in exchange for the third party sponsored community service activities constituted a payment for those services. If the scholarship credits were a payment for services, then the scholarship credits fell outside of the definition of a “qualified scholarship,” and thereby would require the student participants to include the credits in their taxable gross income.

    In the PLR, the IRS decided that the grants were provided to the students strictly to serve public purposes and that the community service exchanged for credits did not serve the private purpose of the Taxpayer. Accordingly, the IRS made the following findings: the services were not being performed for the benefit of the Taxpayer; nor were the students required to perform services in locations specified by the Taxpayer; there was no expectation for the students to accept employment with the Taxpayer once the program was completed; and the funds were not disbursed directly to the students and therefore a proximate relationship did not exist between the students’ community service and the program’s fund disbursement. Based on these facts, the IRS held that the community service performed by student participants was a de minimis service that remained within the purview of the definition of a “qualified scholarship” under § 117(a). As such, the IRS concluded that scholarship credits awarded to students in exchange for community service are not considered payments for student services, and thus, cannot be included as part of the students’ taxable gross income.

    It is likely that with the growing number of scholarship offers and the increasing cost of attending college today, this is not the last time the IRS will have to address the interplay of scholarship awards and taxable exemptions. If you or your institution would like more information regarding education related issues, please email Cynthia A. Augello at caugello@cullenanddykman.com or call her at (516) 357-3753.

    Special thanks to Melissa Cefalu, a law student at Maurice A. Deane School of Law, and Scott Brenner, a law clerk at Cullen and Dykman LLP, for their assistance with this post.

    [1] 26 U.S.C. § 117(a).

    [2] 26 U.S.C. § 117(b)(1).

    [3] 26 U.S.C. § 117(c)(1).

    [4] I.R.S. Priv. Ltr. Rul. 13-28-020 (Apr. 12, 2013).

    [5] This provision provides tax exemption status for corporations that organize and operate for “educational purposes.”