Navigating the Form 1098-T Tuition Statement: Inconsistencies in Reporting
By Terri Gutierrez, Paul Bohrer, and Allen W. McConnellSEPTEMBER 2005 - Tuition and related expenses affect an individual’s tax liability in three ways: taxability of scholarships, education deductions, and education credits. Educational institutions are required to report qualified tuition and related expenses by filing an annual tuition statement with the IRS, Form 1098-T. The amount of scholarships and grants paid to a student must also be included on the Form 1098-T.
Two problems exist with the information reported on the forms. First, the numbers for tuition and related expenses and for scholarships and grants are often not the amounts that should actually be included on a tax return, even when the forms are prepared in accordance with IRS instructions. Second, many colleges and universities prepare 1098-Ts incorrectly and report tuition and related expenses inconsistently.
These issues make it difficult to properly determine the amount of scholarships and grants that is taxable and the amount of education deductions and credits to which a taxpayer is entitled.
Taxability of Scholarships, Education Credits, and Education Deductions
Taxability of scholarships. IRC section 117 excludes scholarships from gross income to the extent they are used for qualified tuition and related expenses, including required books, supplies, and equipment, unless any of the following criteria are met:
In certain situations it may be beneficial to include otherwise excludible scholarships as income. Taxpayers may elect to report nontaxable amounts of certain scholarships as income when they would otherwise not qualify for education credits.
Education credits. IRC section 25A provides for two types of educational tax credits: Hope Credits and Lifetime Learning Credits. Both are based on the amount of qualified tuition and related expenses paid during the year for a taxpayer, the taxpayer’s spouse, and the taxpayer’s dependents. Qualified education expenses include tuition and fees required for enrollment at an eligible educational institution, reduced by scholarship and other exempt income used to pay such expenses. Qualified expenses do not include books, supplies, and equipment. The credit phases out for single, head of household, and qualifying widows and widowers with modified adjusted gross income (AGI) between $42,000 and $52,000 in 2004, and $43,000 and $53,000 in 2005. For married taxpayers filing a joint return, the credit phases out between $85,000 and $105,000 of modified AGI for 2004, and $87,000 and $107,000 in 2005.
The Hope Credit for students attending their first two years of undergraduate education can be claimed for two years only, and it is available for students enrolled at least half-time in a degree program. The maximum Hope Credit per filing year is $1,500 per eligible student, computed as 100% of the first $1,000 of qualified tuition and related expenses and 50% of the next $1,000 of such expenses.
The Lifetime Learning Credit is available to students at all levels of undergraduate and graduate education as well as to individuals enrolled in courses to improve their job skills. The credit is equal to 20% of the first $10,000 of qualifying educational expenses, for a total available credit of $2,000. There are important differences between the two credits: the Lifetime Learning Credit is limited to $2,000 per taxpayer, while the Hope Credit is $1,500 per student. A taxpayer with multiple children in college would have multiple Hope Credits. The Lifetime Learning Credit is available every year for all levels of college education, both degree and nondegree, whereas the Hope Credit is only for the first two years of postsecondary education.
Education deductions. IRC section 222 allows taxpayers an above-the-line deduction for qualified higher-education tuition and related costs incurred for themselves, their spouses, and their dependents. As with the education credits, education must begin in either the current year or the first three months of the following year and be paid for during the current year. The available deduction is $4,000 for 2004 and 2005 for taxpayers with an AGI of not more than $65,000 ($130,000 if married filing jointly). A lesser deduction of $2,000 becomes available to higher-income taxpayers with an AGI not greater than $80,000 ($160,000 if married filing jointly). Taxpayers can take this deduction even if they do not itemize. Married taxpayers filing separately lose the education tuition deduction, as do individuals claimed as dependents on another person’s return. Taxpayers that do not qualify for the tuition and fees deduction may be able to deduct education expenses as an itemized deduction if an employee, or as a business expense if self-employed.
Taxpayers must exercise care in applying the provisions of the education deduction and education credits. The same education expenses cannot be used to claim both a deduction and a credit. Because of the dollar-amount limitations and phase-outs, the two potential benefits need to be assessed together to minimize a family’s overall tax liability.
Form 1098-T Filing Requirements
IRC section 6050S requires eligible educational institutions to file an information return to report information related to allowable education tax benefits for any individual enrolled for any academic period during the calendar year. Form 1098-T (shown in Exhibit 1) must be furnished to the student as well as to the IRS. IRC section 25A(f)(2) defines an eligible educational institution as a school of higher education entitled to participate in federal student aid programs. The IRC and related regulations require that the Form 1098-T include the following information:
Treasury Regulations section 1.6050S-1(a)(2) provides four exceptions to the filing requirements. The first eliminates reporting for nonresident alien students unless such students request that the schools report on their behalf. The second exception applies to noncredit courses. Schools are not required to file Forms 1098-T for courses for which academic credit is not offered, such as continuing education courses for professionals. The third exception relieves institutions of filing for students whose qualified tuition and related expenses are waived or paid entirely with scholarships. Finally, schools are not required to report for students whose qualified expenses are covered by a formal billing arrangement in which the institution bills an employer, a government entity, or another institutional third party and does not maintain a separate financial account for that student.
IRC section 25A(f) defines qualified tuition and related expenses as tuition and fees required to be paid for the enrollment or attendance of taxpayers, their spouses, and their dependents at an eligible educational institution. Related expenses do not include nonacademic fees such as student activity and athletic fees, nor do they include education involving sports, unless such a course is part of a student’s degree program.
Beginning in 2003, schools may elect to report qualified education expenses in one of two ways on Form 1098-T. They may report the aggregate amount of payments received from a student during the calendar year, or they may report the aggregate amount billed to the student. Schools must use the same method every year unless the IRS grants permission to change methods. Any adjustments made during the year to either payments received or amounts billed for such prior years’ expenses must be reported by listing the dollar amount. Likewise, amounts received or billed during the current year may be for an academic period beginning in the following year; schools must indicate this on the form.
Institutions that elect to report amounts received for qualified tuition and related expenses may refer to Treasury Regulations section 1.6050S-1(b)(2)(v), which defines payments received during the year as including payments with respect to an individual from any source up to the amount billed by the university for such payments. Excluded are payments received from scholarships and grants that are required to be applied to nonqualifying expenses such as room and board. The regulations provide four examples:
Example 1. In August 2003, the school bills the student $10,000 for qualified expenses for the Fall semester as well as $6,000 for room and board. The student pays $11,000. In September, the student drops to half-time enrollment and the school credits the student’s account $5,000 for reduction in qualified expenses.
The school will report $5,000 of payments received for qualified tuition and related expenses ($10,000 received less $5,000 credit).
Example 2. Assume the same facts as in Example 1 except that the student pays the entire $16,000, then the school credits $5,000 and refunds $5,000.
The university will report $5,000 of payments received for qualified tuition and related expenses ($10,000 billed less $5,000 refund).
Example 3. Assume the same facts as in Example 1 except that the student is enrolled full-time but decides to move back home. The school then credits her account for room and board and issues a $1,000 refund check.
The school will report $10,000 of payments received for qualified tuition and related expenses.
Example 4. In December 2003, the school bills the student $10,000 for Spring 2004 qualified expenses as well as $6,000 for room and board. In December 2003, the student pays $16,000. In January 2004, the student drops to half-time for the Spring 2004 semester.
The school credits $5,000 to the student’s account for reduction in qualified expenses, but does not issue a refund. In August 2004, the school bills the student $10,000 for Fall 2004 qualified expenses, as well as $6,000 for room and board.
The school applies the student’s $5,000 positive account balance to his $16,000 balance. In September 2004, the student pays $6,000.
In 2003, the school will report $10,000 for qualified tuition and related expenses and indicate that the payments are for an academic period that starts during the first three months of the next year.
In 2004, the university will report two items: a $5,000 refund of payments of qualified tuition and related expenses reported for 2003; and $10,000 of qualified tuition and related expenses received for 2004 ($5,000 credit from Spring 2004 plus $5,000 of the $6,000 cash received in September).
Institutions that elect to report amounts billed for qualified tuition and related expenses will find guidance in Treasury Regulations section 1.6050S-1(b)(3)(iii). Reportable amounts billed are determined by netting the amounts billed during the calendar year against reductions in such amounts made during the same calendar year. If an institution makes reductions during the year in qualified tuition and related expenses that were reported in a prior year, the reductions will be reported separately in Box 3 of Form 1098-T. The regulations include the following examples:
Example 1. In August 2003, the school bills the student $10,000 for qualified expenses for the Fall semester, as well as $6,000 for room and board. In August, the student pays $11,000. In September, the student drops to half-time enrollment. The school credits the student’s account $5,000 for reduction in qualified expenses.
The university will report $5,000 of amounts billed for qualified tuition and related expenses ($10,000 billed less $5,000 credit).
Example 2. Assume the same facts as Example 1, except that in December 2003, the school bills the student $10,000 for Spring 2004 qualified expenses and $6,000 for room and board.
In January 2004, the student pays $16,000. The student then drops to half-time enrollment for the Spring 2004 semester. The school credits the student’s account $5,000 for reduction in qualified expenses but does not issue a refund.
In August 2004, the school bills the student $10,000 for Fall 2004 qualified expenses and $6,000 for room and board. The school then applies his $5,000 positive account balance to the $16,000 billed. In September 2004, the student pays $6,000.
In 2003, the college will report $15,000 for qualified tuition and related expenses ($5,000 billed for Fall 2003 and $10,000 for 2004) and indicate that some amounts billed are for an academic period that starts during the first three months of the next year. In 2004, the college will report two items: a $5,000 reduction of payments of qualified tuition and related expenses reported billed in 2003; and $10,000 of qualified tuition and related expenses billed for 2004 ($10,000 billed for Fall 2004).
Treasury Regulations section 6050S requires schools to report the amount of scholarships and grants received by a student that were administered and processed by the institution during the calendar year. This amount is reported in Box 4 of Form 1098-T. Adjustments such as refunds or reductions made during the year to scholarships reported in a prior year must be reported separately in Box 5. Neither the IRC nor the regulations define “administered and processed.”
Reconciling Form 1098-T to Form 1040
Taxpayers rely on the information reported on Forms1098-T to prepare their tax returns with regard to education expense issues. Returns prepared using the information reported on the Form 1098-T may be incorrect for a number of reasons.
Box 1. Schools that choose to report the amount received by students rather than the amounts billed for qualified tuition and related expenses will use Box 1. The form instructions require an institution to include total payments received from any source during the calendar year, minus any refunds of such payments made during the same calendar year. The number reported in this box is presumably the amount eligible for the education deduction or credit. But this amount could include delinquent payments of prior years’ qualified tuition and related expenses, which would not qualify for either the education credits or the above-the-line tuition-and-fees deduction. Payments made for the first term of the subsequent year are eligible for both the tuition-and-fees deduction and the education credits. The instructions do not say to include such amounts paid by students for a term beginning during the first three months of the next year, although that might be implied because all payments are to be included in Box 1. A detailed report of the student’s account would be needed to ensure that prior-year payments are not included in Box 1 and payments for the first term of the following year are. The Form 1098-T instructions advise students that “the amount shown in Box 1 or 2 may represent an amount other than the amount actually paid” during the year. A better arrangement would be for schools to report the amount actually paid by the student, thereby eliminating guesswork and potential errors in filing.
Box 2. Box 2 is used by schools that choose to report the amount billed rather than the amount paid. An informal survey of schools indicates that most institutions elect to use Box 2 rather than Box 1. The possibility of errors when using Box 2 is even greater than when using Box 1. Instructions for Box 2 advise schools to include total amounts billed during the calendar year for tuition and related expenses, less any reductions in charges made for such amounts during the year. Again, the instructions do not say to include amounts billed for the term beginning during the first three months of the next year. Also, the amount billed is not necessarily the amount paid; a tuition-and-fees deduction or education credit taken based on the amount billed could be incorrect. The actual amount paid for the current year and the first term of the next year can be determined only from the taxpayer’s records.
Box 3. Box 3 includes refunds from the school to students of payments for qualified tuition and related expenses made during the year that were reported on a Form 1098-T in a prior year. If it reduces a tuition-and-fees deduction claimed in the prior year, an amended return may be needed. If it reduces the amount of education credit that should have been claimed in the prior year, the difference is added to the current year’s tax liability. The Form 8863 instructions require the amount by which a prior year’s education credit would be reduced to be included as an additional tax on line 41 of Form 1040, with “ECR” written next to the line.
Box 4. Box 4 must include the total amount of scholarships and grants administered and processed by the school during the year for payment of the student’s cost of attending the institution. Presumably this amount is the starting point in determining the amount of scholarships and grants that are taxable. One pitfall here lies in a filing exception granted to institutions; schools are not required to file a Form 1098-T for students whose qualified tuition and related expenses are entirely waived or entirely paid with scholarships. Such students could still have taxable scholarships and grants if the total amount received exceeds qualified tuition and related expenses. Relying solely on Form 1098-T would ignore any scholarship income in such an exception.
Another issue arises if the IRS uses the amounts reported in Boxes 2 and 4 to match taxable scholarship income to the amount reported on a tax return. In addition to tuition and fees, the law allows students to reduce taxable scholarship income by any required books, supplies, and equipment. Schools have no way of knowing these amounts for each student and could not (nor are they required to) report the amounts on Form 1098-T. The IRS would err by using Form 1098-T as a matching document for taxable scholarship income.
A further limitation to using the amount reported in Box 4 in determining taxable scholarship income is the omission from Form 1098-T of scholarships and grants not administered and processed by the school. These scholarships awarded by outside organizations may be taxable and would not be detected by sole reliance on Form 1098-T.
Box 5. Box 5 is used to indicate any reductions made during the current year to scholarships or grants that were reported on a Form 1098-T for a prior year. This information may affect the amount of taxable scholarship income reported in the prior year, and the amount of tuition-and-fees deduction or education credit claimed in a prior year. It may also indicate the need to file an amended return for the prior year.
Box 6. Box 6 must be checked if any payments received in Box 1 or amounts billed in Box 2 were for qualified tuition and related expenses for the academic period beginning during the first three months of the next year. Expenses paid for the term beginning during January through March of the subsequent year are eligible for both the tuition-and-fees deduction and the education credits. They properly should be included in Box 1 or 2, making Box 6 unnecessary.
If Box 6 is not checked, taxpayers are to assume that all amounts reported as billed in Box 2 relate to the current year’s qualified tuition and related expenses. The amount reported as billed is, in most cases, probably the amount actually paid by students during the year. Schools generally do not tolerate nonpaying students. On the other hand, if Box 2 is used and Box 6 is checked, the amount reported in Box 2 cannot be used with certainty. Students may not have paid the part of the qualified tuition and related expenses that apply to the term beginning in January of the next year.
Boxes 1 or 2, Box 4, and Box 6 provide information that is either incomplete or unnecessary for filing a correct tax return. Taxpayers should not rely solely on Forms 1098-T when preparing returns that involve education expenses.
Numerous inconsistencies in preparing Form 1098-T further diminish the value of the information and sometimes make compliance more difficult. The information in Boxes 2 and 4 is most often reported incorrectly. A sample of nine colleges and universities illustrates inconsistencies in the way schools interpret the instructions and regulations to prepare the Form 1098-T. The results came from actual Form 1098-T issued by each school in 2003 and from telephone conversations with the individual responsible for preparing the Form 1098-T at each of the schools (see Exhibit 2).
All eight schools elected to use the billed method (Box 2) for preparing Form 1098-T. One potential problem with Box 2 that was revealed in the survey pertains to amounts paid by students for the academic period beginning January of the subsequent year. Such amounts are to be included in Box 2, with a checkmark in Box 6 to indicate their inclusion. That five schools did not check Box 6 could mean one of two things: Either students were not billed during the current year for the next semester’s tuition and expenses or, more likely, the schools mistakenly did not include these billings on the Form 1098-T. In the latter case, taxpayers likely understated tuition-and-fee deductions or education credits.
Three errors were identified regarding the reporting of grants and scholarships. One institution chose to include in Box 4 only those scholarships and grants for which the school selected the recipients. The effect was to omit all federal, state, and outside organization grants and scholarships even though the money from these scholarships and grants flowed through the institution and was reflected in students’ accounts. This calls into question the meaning of the IRC section 6050S requirement that all grants “administered and processed” by the institution be reported on Form 1098-T, as well as understates taxable scholarship income on a student’s tax return.
One school elected to report in Box 2 the gross amount of tuition billed when the student qualified for a nontaxable tuition reduction. The school then included the reduction as a scholarship in Box 4. The other schools surveyed properly reduced the tuition billed amount in Box 2 and omitted the reduction from Box 4 for students with identical types of tuition reductions.
Two schools included in Box 4 scholarships and grants for the January through March 2004 academic period. This box is to include only those amounts received by students during the calendar year and could cause scholarship income for the year to be overstated on students’ tax returns. One school compounded the problem by not including the tuition for the same January through March period in Box 2. The result was a mismatching of scholarships and grants to the applicable tuition.
The significant inconsistencies in preparing Form 1098-T cause the amount of taxable income or education credits to be computed incorrectly for some individuals if taxpayers use the numbers reported on Forms 1098-T. CPAs are faced with a dilemma: Do they use the numbers on the Form 1098-T when they know the amounts may be incorrect, or do they ignore the amounts entirely and have taxpayers provide copies of all bills and payments? If they use the numbers on the Form 1098-T, they are probably violating the AICPA Statement on Standards for Tax Services 3 and section 10.34(c) of IRS Circular 230, which allow the use of information provided by clients unless there is reason to believe the information is not correct, whereupon reasonable inquiries must be made. On the other hand, ignoring Form 1098-T and using information provided by taxpayers will cause the returns to not match Forms 1098-T and may lead to unnecessary audits.
Two cases illustrate the problem.
Another issue that Form 1098-T does not help relates to the designated use of a scholarship or grant. The regulations require scholarships and grants that are specifically designated for tuition to be offset first by tuition, then by required books, supplies, and equipment, when determining the taxable amount. Form 1098-T does not require schools to indicate whether a scholarship has a specific designation. Preparers must obtain this information from taxpayers. Under certain circumstances, particularly when the scholarship is not designated to be used for tuition, it is better to have parents claim a student as a dependent, report scholarship income on the student’s return, and use the amount of scholarship that was taxable as a basis for an education credit on the parents’ return. Two worksheets can help isolate the amounts to be shown on the student’s and the parents’ 1040s. Usually when there is scholarship income the family will save tax if the income is reported on the student’s return and the student is claimed as a dependent on the parents’ return. This often results in an education credit on the parents’ return that is greater than the amount of tax paid by the student.
Example. A Form 1098-T for 2005 shows $2,000 of qualified tuition and related expenses in Box 2 and $7,300 of scholarships and grants in Box 4. None of the scholarships and grants is designated for tuition only. In addition, the student has receipts for $300 of required books, supplies, and equipment, and may be claimed as a dependent on his parents’ return. Exhibit 3 shows the completed worksheet.
In option 1, the student reports $5,000 as taxable scholarship income. If the student is single and has no other income, he pays no tax, because the income is less than the standard deduction ($5,000). The parent who claims the student as a dependent does not get an education credit or deduction, because none of the scholarship income is taxable.
A second option results in a net family tax savings. The student could deduct less than the full amount of qualified expenses and pay some tax on the scholarship. The taxable amount of scholarship would then be available for the parents to claim as a deduction for tuition and fees or for an education credit. For example, the student could deduct only $1,500, rather than $2,000, of qualified tuition and expenses on his tax return. This would leave $5,500 of taxable scholarship income on the student’s tax return and $500 of taxable income after deducting the standard deduction. The student would pay tax of about $50. The parent claiming the student as a dependent would use $500 as qualified tuition and related expenses and receive either a Hope Credit of $500, a Lifetime Learning Credit of $100, or an education deduction of $500.
If the scholarship or grant is designated as a tuition scholarship, a two-step process is necessary. The worksheet assumes the same facts as in the above example, except that the $2,000 scholarship amount in Box 4 is designated for tuition. The flexibility for net family tax savings is gone because the tuition must be deducted first from scholarship income to determine the net amount of scholarship income. All qualified tuition and related expenses are used up on the child’s return, leaving none available for the parents to use to get either an education credit or a deduction. The student will pay no tax, because the taxable scholarship income (reduced by the $300 for books and supplies) is less than the standard deduction amount. The parents will not get an education credit or deduction because the tuition was used to reduce the taxable scholarship income, leaving none available for the credits or deduction.
Although in these examples the student had no other income, this is not likely to be the case in the real world. The inclusion or exclusion of certain scholarships and grants and the order in which tuition can be deducted to determine the amount of taxable scholarship can significantly affect how much tax will be paid by the student and how much of the credit or deduction can be claimed by the parents.
Terri Gutierrez, PhD, CPA, CFE, is a professor, Paul Bohrer, CPA, is a professor emeritus, and Allen W. McConnell, CPA, is a professor, all in the department of accounting at the Monfort College of Business, University of Northern Colorado, Greeley, Colo.