Switched Keys

See Tax-Aide Repents on Education Credits: I Win! for an update on this.

I’ve been talking and writing about education credits intermittently for a year. I’ve written articles, notified accountants, designed flyers, prepared tools for tax professionals, and am readying for making presentations. My latest contribution explains how to calculate and claim AOTC in TaxWise. What I’ve been talking about is the ability to include some scholarships and grants in income in order to maximize education credits. The IRS has also been on a mild-mannered crusade on the same subject. Pub 970 has discussed this in the past, but now the encouragement has been added to the 8863 instructions and in 2015 will be included on the back of the 1098T. In a 2014 report to Congress even the Treasury Department discussed coordinating AOTC and Pell grants, releasing a fact sheet that explains how Pell grant recipients can get the credit.

Knowledge of Treas. Reg. Section 1.25A-5 which permits this is still very limited even though the regulations are more than a decade ago. But now there is a new strain of ignorance of that regulation which has much the same effect as total ignorance. They recognize that some scholarships can be included in income to increase qualifying expenses for the AOTC, but their rules are that the regulation only applies if, and to the extent, the taxpayer has paid some of their own money to the institution. That is being propagated by Tax-Aide, the volunteer tax preparation program of the AARP Foundation.

Before going on, I need to say that this criticism should not be a reflection of the local Tax-Aide services you may be aware of. I started working with the local Tax-Aide site last year and I found that they were knowledgeable, careful, and conscientious when preparing individual tax returns. They do not have the tax knowledge that you might find in an Enrolled Agent or CPA focused on taxation, but I would recommend them before I would suggest using H&R Block, TurboTax, and some other tax firms. The training is extensive and the accumulation of tax knowledge after years of volunteer work is significant. The main office, however, has it wrong on the subject of education credits. I discovered that from a worksheet that they provided on their volunteer website and emailed this observation. Emails are edited for brevity.

I'm glad to see that Tax-Aide understands the ability to include some grants in income to maximize education credits. The idea of being able to use a spreadsheet as a way to calculate the credit and taxable scholarships is really good, too.

Unfortunately, the Excel spreadsheet is confusing and does not always work properly. For example, if you do not include an amount for Taxpayer's money or student loans the calculation doesn't work. Many students would have only expenses and grants.

In the response from Tax-Aide Operations I received the following information.

There is a difference of interpretation between the IRS (Form 8863 instructions) and the Treasury Department (white paper from this summer). The white paper implies that unrestricted grants can be applied to non-qualifying expenses (like room and board), made taxable on the student's tax return, and therefore all qualifying expenses (tuition and fees and books etc.) can be used toward an education credit. But, the IRS instructions for Form 8863 make it clear that if the non-qualifying expenses are paid with the scholarships or grants, then the qualifying expenses must be paid by check, credit card, loan, etc. The rules for claiming the credits are based on expenses that are "paid." If the scholarships went for non-qualifying expenses, how were the qualifying expenses paid?

Therefore, the calculator requires that there be some "own money" be in the student account--either credit card, student loan, check or other payment made by the student or on behalf of the student. If there is no "own money," there can be no education credit.

I have not seen even a draft of the 2014 Pub 970, but each of the examples in the 2013 Pub 970 includes own money, as do the examples in 26 CFR 1.25A-5.

SPEC headquarters is aware of this difference of opinion: that some people believe that if the tax is paid on the grant, then it is not a tax-free grant, and expenses do not need to be reduced by the amount of the grant. IRS is in negotiations with Treasury to reach a definitive decision on this question. They have promised to send a Volunteer Alert when there is the final agreement between IRS and Treasury. In the meantime, the IRS has issued final instructions for Form 8863. "Own money" is necessary to claim an education credit. The education calculator incorporates the current IRS instruction.

My initial response

The regulations do not mention an "own money" requirement. In fact, Example 3 in Pub 970 demonstrates that no "own money" is required to be paid for qualifying expenses. The student received a $5600 scholarship to pay for $5600 in expenses. He treated $1600 as tax-free and included the other $4000 in income so he could receive the maximum education credit. With that example it is clear that the IRS requirements do not ask how the qualifying expenses were paid. It's obvious that the expenses were paid using the scholarship money that was included in income.

Although the example referred to example 1 and 2, which mentions 4400 paid for room and board, that is irrelevant since it is a non-qualifying expense. Everyone has living expenses that must be paid.

IRS and Treasury have different interpretations of this part of the code. We asked for clarification, and SPEC has promised to issue a volunteer tax alert when there is a definitive answer. In the meantime, Tax-Aide will follow the IRS's interpretation as set forth on page 4 of the recently released 8863 instructions.

In my final message with them I provided the following recommendations and extensive analysis that you might find educational.

Tax Administration

I’m confused by what you refer to as a conflict between the IRS and the Treasury department. Perhaps you are confused about tax administration. The Treasury Department and the IRS are not competing departments. The Internal Revenue Service is a function of the Treasury Department.

That’s why throughout the Internal Revenue Code there is often a section that says something to the effect of “The Secretary may prescribe…”, referring to the Secretary of the Treasury. Internal Revenue Code Section 25A(j) says concerning regulations for the education credit,

The Secretary may prescribe such regulations as may be necessary or appropriate to carry out this section…

Furthermore, those regulations are appropriately called Treasury Regulations even though the IRS releases them. The IRS releases these regulations every week. They are generally released in a Treasury Directive, such as T.D. 9034[1], which covers education credits. They are released by the Internal Revenue Service and have a header that reads

DEPARTMENT OF THE TREASURY
Internal Revenue Service

Tax Law

It’s also important to understand the difference between sources. The following web site clearly describes the force of different types of information.

http://www.irs.gov/Tax-Professionals/Tax-Code,-Regulations-and-Official-Guidance

The Internal Revenue Code contains the law passed or amended by Congress. The regulations are provided by the IRS as a way to enforce the Internal Revenue Code. Together these two have the force of law. The Internal Revenue Code and Treasury Regulations are the sources cited in tax cases. There are other forms of documents, but the Internal Revenue Manual points out specifically that IRS publications do not have the force of law.

4.10.7.2.8  (01-01-2006)
IRS Publications

1. IRS Publications explain the law in plain language for taxpayers and their advisors. They typically highlight changes in the law, provide examples illustrating Service positions, and include worksheets. Publications are nonbinding on the Service and do not necessarily cover all positions for a given issue. While a good source of general information, publications should not be cited to sustain a position. [2]

Likewise, the Treasury Department handout you referred to, even though it was released by someone at the Department of Treasury, has no basis in tax decisions.

Education Credit Regulations (the proof)

I can see how you might misunderstand the 8863 instructions or "read into" the examples. I think a look at the actual regulations (tax law) will help you understand that your assumptions are incorrect. In fact, the regulations prove that "own money" is not required. The regulations allow the taxpayer to consider amounts paid by some scholarships to be included in income in order to increase the credit, and the regulations in this case ARE the SOURCE documents for this, not an interpretation.

Your reference to amounts paid by cash, check, student loan, etc. reminds me of the AARP training we received where it was noted that it doesn't matter where the money comes from. Student loans are as good as cash, as long as the amounts are paid. The alternate reading would contradict the regulations.

First, qualified expenses paid include amounts paid for a student, from any source.

Treas. Reg. 1.25A-5[3]

(b) Educational expenses paid by a third party—

(1) In general. Solely for purposes of section 25A, if a third party (someone other than the taxpayer, the taxpayer's spouse if the taxpayer is treated as married within the meaning of section 7703, or a claimed dependent) makes a payment directly to an eligible educational institution to pay for a student's qualified tuition and related expenses, the student is treated as receiving the payment from the third party and, in turn, paying the qualified tuition and related expenses to the institution.

According to these regulations amounts paid for qualified expenses can be from any source, taxpayer, child, rich uncle, granny, and even scholarships and grants. No "own money" is required. That qualified expenses include amounts paid from scholarships and grants is further indicated by the next subsection

 (c) Adjustment to qualified tuition and related expenses for certain excludable educational assistance—

(1) In general. In determining the amount of an education tax credit, qualified tuition and related expenses for any academic period must be reduced by the amount of any tax-free educational assistance allocable to such period. For this purpose, tax-free educational assistance means—

(i) A qualified scholarship that is excludable from income under section 117;

If scholarships and grants were not included in the amount of qualified expenses paid, then you would not be able to reduce those expenses by that amount.

Note: The text makes it even more clear by saying “the student is treated as receiving the payment from the third party and, in turn, paying the qualified tuition and related expenses to the institution.” There is no distinction based on the source. Everything is considered paid by the student.

Second, not only does the regulation define what qualified expenses are, it prescribes this as the method of adjusting them. Given the qualified expenses paid, the taxpayer reduces them by tax-free scholarship amounts.

It’s a very simple process.

Third, if the taxpayer can treat a scholarship amount (Pell grants) as taxable, he can choose NOT to reduce the expenses by that amount if he includes it in income.

 (3) Scholarships and fellowship grants. For purposes of paragraph (c)(1)(i) of this section, a scholarship or fellowship grant is treated as a qualified scholarship excludable under section 117 except to the extent—

(i) The scholarship or fellowship grant (or any portion thereof) may be applied, by its terms, to expenses other than qualified tuition and related expenses within the meaning of section 117(b)(2) (such as room and board) and the student reports the grant (or the appropriate portion thereof) as income on the student's federal income tax return if the student is required to file a return; or

That is also a simple process.

In my first TaxWise example, the student had qualifying expenses of 7720 and reduced them by 3720 tax-free scholarship money to get 4000 in adjusted qualified expenses. The remaining scholarship funds (5250 - 3720 = 1530) are included in income. My method categorizes the expenses to make it understandable, but returns the same results.

IRS Tips and notices summarize this very process in numerous places, including the 8863 instructions

You may be able to increase the combined value of an education credit and certain educational assistance if the student includes some or all of the educational assistance in income in the year it is received.

That shows what to do (increase credit) and how to do it (include assistance in income).

Examples given in the publications and instructions are useful in giving scenarios, but they only illustrate the regulations. They don't alter them, and they certainly don't contradict them. All of the examples in the publications and instructions can be verified with the method given in Treasury Regulation 1.25A-5.

It appears Tax-Aide Operations do not consider the tax code and IRS regulations, which are the definitive sources for tax law. Their policies and procedures are solely based on what they can surmise from IRS publications and examples. While the plain language of the regulations is unmistakable, the examples and other sources are more obscure.

In my initial research of this subject a year ago I found few court decisions to clarify these regulations, probably because it is so clear. There is not likely to be any new cases that can resolve the regulations and obscurities possible in the examples simply because the results would not be adverse to an IRS claim. The process of evaluating the inclusion of scholarships to maximize the credit is not even listed in the Internal Revenue Manual. As the credit becomes better known, though, we may see negligence cases against paid preparers that do not claim the credit, or do not inform clients about the benefits these regulations provide. Over a four year period, the claim could approach $10,000 per student. For taxpayers that rely on Tax-Aide, however, that is an unfortunate loss that cannot be remedied after the time limitations for amending tax returns.