Scholarship and fellowship grants to students seeking educational degrees are generally tax free if they are used to pay for tuition, required enrollment fees, books, and other course materials. However, they are taxable if the money is used for room, board, research, travel, or other expenses. It’s important to keep good records of how this money is spent. Otherwise, the IRS may conclude that you used your fellowship money for something other than tuition or other nontaxable purposes.
Unfortunately, one full-time student pursuing a doctorate in biophysics at Harvard University learned this the hard way. In 2009, the American Society for Engineering Education awarded the student a fellowship grant that included a $18,375 cash stipend. On his taxes for the year, the student included only $8,208 of the stipend as taxable income. He excluded the $10,167 balance because he said he used that money to pay off student loans and other education-related expenses.
The IRS audited him and concluded that the $10,167 should have been included as income. The tax court agreed because he did not provide the IRS or tax court with any receipts, bank or credit card records, or similar documentation to substantiate the educational expenses he said he paid with the fellowship grant. (Wang v. Comm'r, T.C. Summary 2014-39.)
IRS proposed regulations provide that a student must maintain records to establish the total amount of tuition and related expenses and the amount of the scholarship or fellowship grant used to pay for those expenses. These records may include copies of relevant bills, receipts, canceled checks, or any other documentation that clearly reflects the use of the money. A student must also retain documentation that establishes the notification date of the grant, the receipt of the grant, and the conditions and requirements of the grant. However, students generally are not required to trace particular grant dollars to particular qualified expenditures. (Prop. Reg. Sec. 1.117-6(e)).) For more details, see IRS Publication 970, Tax Benefits for Education.