Tuesday, May 20, 2008


It doesn’t matter who actually pays the qualified tuition and fees to the school. The education tax credit or Deduction for Tuition and Fees is claimed by either the student himself, who is claiming himself/herself on his/her own tax return, or to the person(s) who is claiming the student as a dependent. In the case of education for the taxpayer or a spouse, it is obvious that the credit or deduction is claimed on the single or joint return (but not on a separate return). If the student is a dependent child, the parents who claim the child as a dependent get the tax benefit.

What if grandparents pay the expenses directly to the college or university for a grandchild who is claimed as a deduction on his/her parents’ joint tax return? The parents get the credit or deduction and not the grandparents.

What if the dependent child, or his/her parents, takes out a student loan to pay for the tuition and fees? If the parents claim the child as a dependent on their return they get the credit or deduction. It makes absolutely no difference if the proceeds of the loan are paid directly to the school or first to the student, or who will ultimately pay off the principal on the loan.

A direct payment to a school by a “third party” is treated as if the money was given to the student and the student paid then paid the school.

What if the student himself/herself actually pays the school costs out of his own pocket? If he/she is claimed as a dependent on his parents’ joint return the parents get the credit or deduction.

IRS Field Service Advice FSA 200236001 addresses a special situation that provides an opportunity for some tax planning. It discusses whether a dependent can claim an education tax credit.

James Q Taxpayer, the 19 year old son of John Q and Jane Q, is an unmarried full-time college student who had net taxable income for the year in question. John and Jane provided more than half of James’ support for the year and are entitled to claim him as a dependent.

During the year James incurred expenses that qualified for the HOPE education tax credit. However, John and Jane's modified Adjusted Gross Income (MAGI) was in excess of $160,000.00, and could not claim the credit (nor the deduction).

James' tax liability, before any credits, was more than the amount of tax savings John and Jane would have realized by claiming James as a dependent. For example James’ tax liability is $1,100 and the tax benefit to John and Jane for claiming James as a dependent would be $952 ($3,400 x 28%) – or less if the exemption was partially phased-out due to excessive AGI. Or "0" if John and Jane are victims of the dreaded Alternative Minimum Tax (AMT).

John and Jane, although entitled to, did not claim James as a dependent on their 1040. James filed a tax return, but, because he qualified as a dependent of John and Jane, did not claim an exemption for himself. James did, however, claim the HOPE Scholarship credit on his return.

It is important to note that because the parents (John and Jane) could claim a dependency exemption for the "child" (James), he (James) could not claim an exemption for himself. IRC Section 151(d)(2) states that a child cannot claim a personal exemption for himself/herself if the parent(s) is eligible to claim that child as a dependent.

But the FSA affirms that, as the parents did not claim the child as a dependent, the child (James) was entitled to claim the HOPE Scholarship credit on his return if he met the other eligibility requirements.

Using the number above the net federal income tax savings by using this strategy is anywhere from $148 to $1,100! Of course state tax consequences would also have to be considered. This tax planning opportunity also applies to the “above-the-line” deduction for student loan interest.

In these posts on education tax benefits I have frequently referred to a “modified” Adjusted Gross Income, or MAGI (no gift from this Magi). For purposes of the education tax credits you begin with the AGI and add-back any foreign earned income exclusion, foreign housing exclusion or deduction, and American Samoa, Guam, Northern Mariana Islands and Puerto Rico resident income exclusions. In the case of the Deduction for Tuition and Fees you also add back the “Section 199” deduction for “domestic production activities”. As you can see, for most taxpayers the actual AGI will apply.

Any questions?

PS - Check out today's posting at ANYTHING BUT TAXES to find out how to solve the NJ budget crisis.

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