The Lifetime Learning Credit (LLC) and the American Opportunity Credit (AOC) offer significant tax savings for education expenses. This second article in a two-part series for parents of college students explains in detail a tax-saving strategy involving scholarships and the Lifetime Learning Tax Credit. It explains how a taxpayer can utilize a strategy of including tax-free scholarships in income to potentially save on overall taxes for a family; it is particularly relevant after the recent change to the “kiddie tax” under the Secure Act of 2019.
College expenses are among the largest expenses for parents funding their children’s education. Fortunately, various types of educational assistance and tax credits are available. Educational assistance includes scholarships and fellowship grants and is generally tax-free if it is used to pay for qualified educational expenses such as tuition, required fees, and course-related expenses for books, supplies, and equipment (IRC section 117). Parents who pay educational expenses for their children are also eligible to claim the American Opportunity Credit (AOC) or the Lifetime Learning Credit (LLC) to reduce their overall tax liability, although these are phased out for high-income taxpayers.
Part 1 of this series introduced a counterintuitive tax-saving strategy to include scholarships in income. Although the natural tendency is to exclude scholarships from income, including scholarships can qualify some taxpayers for more tax credits, potentially reducing their overall tax liabilities (IRS Publication 970, Tax Benefits for Education, 2019, pp. 16, 28). Many taxpayers and tax advisors may not be aware of this strategy, and tax preparation software generally does not address it. This article will expand upon Part 1 of this series by offering a detailed guide for CPAs and tax advisors as to whether and how to save taxes using the LLC.
Although the strategy may save significant taxes, its implementation is complex. With the guidance below, CPAs and tax consultants can easily find out the optimal amount of scholarship for taxpayers. According to the National Center for Educational Statistics (NCES), since 2011 only 41.6% of students graduate within four years (https://bit.ly/3xSNQNl). Because a taxpayer can only claim the AOC for a maximum of four years [IRC section 25A(b)(2)], the NCES statistics imply that the LLC may be applicable to parents of college students almost 60% of the time. Due to the coronavirus (COVID-19) pandemic and economic recession, it may take some students even longer to graduate from college, likely further increasing the usage of the LLC (J. Marcus, “While Focus is on Fall, Students’ Choices about College will Have a Far Longer Impact: Delaying Enrollment, Slowing to Part Time Lower the Odds of Ever Getting a Degree,” https://bit.ly/2W3gXk3, 2020).
The article is particularly relevant due to the Setting Every Community Up for Retirement Enhancement Act of 2019 (Secure Act), which repealed the “kiddie tax” rules set by the Tax Cuts and Jobs Act of 2017 [TCJA section 1(j)]. The Secure Act retroactively changed the kiddie tax to its pre-2017 rules (Secure Act section 501, Title V). The tax-saving strategy in this paper is based on kiddie tax rules under the Secure Act. Importantly, eligible taxpayers can apply this strategy not only for 2020 returns, but also for amending 2018 and 2019 returns. The latter may be particularly appealing for families in which dependent children had large unearned income in 2018 and 2019.
The Lifetime Learning Credit
The LLC is worth up to $2,000 in tax credits as long as a student enrolls in a postsecondary education institution. The calculation is based on qualified education expenses, which include tuition and required fees but exclude course-related fees unless they are paid directly to the student’s educational institution [IRC section 25A(f)(1)]. The LLC is equal to 20% of the first $10,000 of qualified education expenses [IRC section 25A(c)(1)]. Parents who pay tuition for their children can claim the LLC on their own tax returns.
The Principle of No ‘Double Dipping’
Taxpayers should be aware of potential problems when they receive scholarships and apply for the LLC in the same year. The IRS does not allow “double-dipping” for education tax benefits. For example, if a taxpayer excludes scholarships from her income, then the IRS assumes that the taxpayer uses the scholarship to pay for qualified education expenses such as tuition and fees. The “no double-dipping” principle forbids the taxpayer from using the same tuition and fees as a basis to claim the LLC (IRS Publication 970, p. 25).
Taxpayers can use adjusted qualified education expenses (AQEE) to determine the educational expenses used to calculate the LLC. AQEE is the total amount of qualified education expenses less tax-exempt scholarships (IRS, “Determining Qualified Education Expenses,” https://bit.ly/3xShH8s, 2019). Although a taxpayer can exclude all of her scholarship from income, doing so may reduce her AQEE and LLC. If she includes some scholarship in income, she may be eligible for more LLC and have a lower tax liability overall (IRS Publication 970, p. 28).
Jessica is a fifth-year college student whose tuition and required fees are $12,000 in 2020. Jessica lives at home, and her parents David and Nancy claim her as a dependent on their tax return. David and Nancy also pay for Jessica’s tuition and required fees, and want to claim the LLC based on these expenses. Jessica receives a scholarship of $7,000 from her university in 2020, works a job and files her own tax return. If Jessica does not include any scholarship in her income, then the tax-exempt scholarship is $7,000. The AQEE is $5,000 [12,000 – 7,000], based upon which David and Nancy can claim $1,000 [5,000 × 20%] of the LLC. If Jessica instead includes $5,000 scholarship in income, her tax-exempt scholarship becomes $2,000 [7,000 – 5,000]. The AQEE becomes $10,000 [12,000 – 2,000], and David and Nancy can claim $2,000 [10,000 × 20%] of the LLC. Therefore, David and Nancy’s tax credit will increase by $1,000 if Jessica includes $5,000 scholarship in her income.
The Kiddie Tax after the 2019 Secure Act
The kiddie tax primarily concerns a child’s unearned income—such as interest income, capital gains, and dividends—and it can be complex to calculate. It applies to children under 18 or full-time college students who are under 24 and do not earn more than half of their support [IRC section 1(g) (2)]. Generally, earned income includes wages and bonuses but does not include interest income, dividends, and capital gains [IRC section 911(d)(2)]. If a full-time college student under 24 does not provide more than half of her support, her parents can claim her as a dependent on their tax return. However, the student’s standard deduction is limited to the greater of $1,100 or earned income plus $350, instead of the standard deduction of $12,400 in 2020 [Revenue Procedure 2019-44 section 3(16)].
Prior to the TCJA, a child’s unearned income above a certain threshold was subject to a kiddie tax based on the parents’ tax rates, which is usually a higher rate than that of the child/student. The TCJA significantly changed the rules for the kiddie tax, and unearned income above the threshold is now taxed at the estates and trusts tax rates [TCJA section 1(j)]. Because the estates and trusts tax rates increase much more quickly than regular income tax rates, however, the TCJA unintentionally increased the kiddie tax of some dependent children, such as children of military survivors (Congressional Research Service, “The Kiddie Tax and Military Survivors’ Benefits,” https://bit.ly/3xSyYyC, 2020). To address this issue, Congress included a clause in the Secure Act to revert the kiddie tax calculation back to pre-TCJA rules for tax year 2020 (section 501, Title V). Thus, unearned income above $2,200 in 2020 will be based on the parents’ marginal tax rate. The IRS also allows taxpayers adversely affected by the kiddie tax under TCJA in 2018 and 2019 to file amended tax returns for refunds.
Exhibit 1 provides two calculation examples of the kiddie tax based on Examples 2 and 3.
Calculating Adam’s Kiddie Tax and Total Tax in 2020
Adam is a fifth-year college student. He is 23 years old and lives at home with his parents, who pay for all his college expenses, including $10,500 in tuition and $500 in required fees. Adam earns $2,500 from his job and $1,500 in interest income in 2020. His parents claim him as a dependent on their tax return, but Adam also files a tax return for himself. According to Exhibit 1, his total tax is $115 after taking into account the kiddie tax.
Assume all the information in Example 2 remains the same, except that Adam’s salary and interest income are now $6,000 and $5,500 respectively. Taking into account the kiddie tax, his total tax is $581.
How to Determine the Optimal Amount of Scholarship Inclusion
Including scholarships in a student’s income affects the student’s and parents’ tax returns differently. Although the parents may be eligible for a higher tax credit, the student may be subject to additional taxes, especially the kiddie tax, because scholarships are considered unearned income if included (IRS Publication 929, “Tax Rules for Children and Dependents,” 2019, p. 8). Whether there is an overall decrease in tax liability for the entire family depends upon various factors and can be a complicated calculation, even for CPAs and tax advisors.
Exhibit 2 provides a step-by-step guide to determine the optimal amount of scholarship that should be included in income based on AQEE and unearned income (UI). AQEE determines additional tax credits, while UI determines additional kiddie tax. Taxpayers need to consider both variables when deciding on the optimal amount of scholarship inclusion. As more scholarships are included in income, both AQEE and UI may increase; whether to increase the scholarship inclusion depends upon whether this inclusion leads to more tax credits or higher kiddie tax. Because the kiddie tax calculation is complex and depends on several factors, Exhibit 2 presents a simplified calculation.
Computing Scholarship Inclusions for the Lifetime Learning Credit (LLC) Based on Adjusted Qualified Education Expense (AQEE) and Unearned Income (UI)
Example 4: Scholarship Inclusions and the LLC
Exhibits 3 and 4 provide kiddie tax calculations and net family tax savings, respectively, under four different scenarios to apply Exhibit 2. The examples involve different scholarship inclusions and tax savings. All cases assume the same facts as Example 2, with the exception that Adam also receives a schol arship of $4,000, which can be used for any educational expenses. If Adam does not include any scholarship in his income, his total tax burden is $115, consistent with Example 2. Adam’s AQEE for the LLC is $7,000 [10,500 + 500 – 4,000], and his parents can already claim $1,400 [7,000 × 20%] for the LLC. Exhibit 3 lists Adam’s taxes for four different scholarship inclusions.
Figuring Adam’s Kiddie Tax and Total Tax with Scholarship Inclusions in 2020
Scholarship Inclusions, the Lifetime Learning Credit, and Net Tax Savings
Exhibit 4 presents overall tax savings for Adam and his family for four different amounts of scholarship inclusion. Exhibit 4 ignores other factors that could affect the calculation of scholarship inclusion and assumes that Adam’s parents have sufficient taxes to absorb any additional tax credits. In Case 1, the scholarship inclusion is $1,000 and Adam’s AQEE increases to $8,000 Adam’s tax liability and his parents’ LLC increase by $106 and $200, respectively, resulting in a $94 tax saving for the entire family. In Cases 2 and 3, scholarship inclusions are $2,000 and $3,000, and the family’s overall tax savings increase to $174 and $254, respectively. In the first three cases, the overall family tax savings increase as Adam includes more scholarship in his income. In Case 3, however, Adam’s AQEE after scholarship inclusion is $10,000, which is the highest AQEE that taxpayers can use to claim the LLC. Exhibit 2 suggests that the optimum amount of scholarship inclusion for Adam is $3,000. As shown in Case 4, if Adam includes $1,000 more scholarship inclusion in his income than in Case 3, his total taxes increase from $461 in Case 3 to $581 in Case 4, but his parents’ tax credit remains $2,000. Therefore, the family as a whole pays $120 more taxes in Case 4 than in Case 3.
This article explains in detail an unconventional tax saving strategy involving the lifetime learning credit, scholarships, and the kiddie tax for parents of college students, following the passage of the Secure Act. Although conventional wisdom suggests excluding items from income whenever possible, including scholarships in income can help some taxpayers qualify for more LLC and reduce a family’s overall tax burden. Because CPAs and tax advisors are not necessarily always aware of the intricacies associated with education expenses and credits, the advice above may yield incremental benefits for college students and their families.