This Blog Post has been contributed by my friend Chuck Moore.
Note: this BLOG is NOT meant to give any tax or legal advice. Please consult a licensed expert at all times.
What is a scholarship?
According to IRS Publication 970:
“A scholarship is generally an amount of money paid to a college or given to the student in order to pay for the pursuit of an education. The student may be either an undergraduate or a graduate.”
Most scholarships are paid to the college and used for educational expenses incurred by the student when attending the educational institution; however, some scholarships can be used to pay for personal expenses of the student during his or her undergraduate or graduate studies.
Many taxpayers assume that all scholarships are always tax-free. Another assumption is that a scholarship is defined in the same way by the college and the IRS. This is not true.
Colleges and universities define scholarships and grants as funds that are used for the benefit of the student based on the need of the student or on his or her merit.
On the other hand, the IRS defines scholarships and grants as qualified, non-qualified, restrictive and non-restrictive. The IRS does not care whether the scholarship or grant was given to the student based on need or merit; however, the IRS is concerned as to how the scholarship or grant is to be used.
- If the scholarship or grant is used to pay for qualified educational expenses, the scholarship or grant is tax-free to the student.
- If the funds are used to pay for non-qualified expenses, the scholarship or grant is taxable to the student.
Scholarships can be given out to students based on several financial and non-financial reasons. Most scholarships received by students have NO repayment requirement to the donor, regardless if the student graduates or drops out before graduating.
The only exception to this rule is, if the scholarship is tied to a future or present work obligation to the donor. In this case the student MUST claim the scholarship as “taxable income” in the year it is received. It the student DOES NOT work for the donor after graduation, then the scholarship must be repaid with or without interest. In order words, the IRS looks at these types of scholarships as present or future compensation due to the required work or repayment obligations.
Now that you understand the general makeup of what a normal scholarship is and how it is treated by the IRS, let’s take a twist and go in a different direction.
There is a hybrid type of scholarship that is being used by several colleges across the country called a Moral Obligation Scholarship. I will give you a few examples of some of the moral obligation scholarships later in this publication.
So how does this hybrid scholarship work?
Any donor (non-profit organization), college, or university can give out a moral obligation scholarship. The scholarship can impose on the student special restrictions and requirements in order to receive the funds. The scholarship could require:
- a certain GPA or ACT/SAT test score,
- demonstrate a financial need or no need,
- and other restrictions that the donor or college feel is important.
When the scholarship is issued, the student will be notified that the scholarship is a moral obligation scholarship. In the notification, it will inform the student that the scholarship has a moral obligation to be repaid back to the donor or college once the student has gained employment after graduation.
Normally, the student (upon graduating) will receive a letter from the donor or college informing the student of the amount of funds that were given to the student during their stay in college and will request the scholarship to be repaid.
The letter could request the scholarship to be paid in full or the donor or college could agree on monthly, quarterly, semi-annual or annual payments over a determined time period.
Now here is where it gets really interesting.
A moral obligation scholarship is NOT a true scholarship NOR is it a legal binding debt obligation. It could be looked at as a gift of funds with a moral obligation to be repaid.
(To see examples of the language being used in these types of scholarships Google the University of Michigan’s Engineering Scholarship, the Fred and Kit Bigony ‘Pay-it-Forward’ Scholarship Program Florida Atlantic University and the Dyson Moral Obligation Scholarships at Pace University.)
Since the scholarship carries a moral obligation of repayment, the student CAN elect to repay the scholarships or they can elect to ignore the donor and college’s request and pay NOTHING.
If the student elects NOT to repay the scholarship, the donor or college DOES NOT have a legal claim for the repayment, because the scholarship has a MORAL obligation clause within the scholarship agreement.
If the student elects to repay the scholarship, any payment or payments made to the donor (non-profit organization) or college could be looked upon as a charitable contribution and 100% tax deductible as long as the student can complete IRS Schedule A (itemized deductions).
Colleges and states are facing major financial problems nationwide. If colleges and other non-profit organizations would start to apply a “moral obligation” to the college scholarships they hand out, then maybe they could potentially recoup hundreds of thousands of dollars of scholarship monies that could help future students pay for and obtain their degrees as well. The key for this type of scholarship to work of course is that the scholarship recipient MUST fulfill their moral obligation to pay it forward.