Eligible institutions generally include any accredited public, nonprofit, or proprietary post-secondary institution eligible to participate in the student aid programs administered by the Department of Education.

The following table defines the eligible and ineligible expenses that are used in determining the education expenses. This table also includes Sec 529 expenses (see chapter 5.05). There are differences between expenses that qualify for the AOTC and LLC and Sec 529 distributions. (Reg. § 1.25A- 2(d)):

The regulations provide that solely for education credit purposes, if a third party (someone other than the taxpayer or a claimed dependent) makes a payment directly to an eligible educational institution for a student’s qualified tuition and related expenses, the student is treated as receiving the payment from the third party, and, in turn, paying the qualified tuition and related expenses.  Furthermore, qualified tuition and related expenses paid by a student are treated as paid by the taxpayer if the student is a claimed dependent of the taxpayer. (Reg §1.25A-5(a), Reg §1.25A-5(b)) 

The regulations also provide that if a taxpayer is eligible to but does not claim a student as a dependent, only the student can claim the education credit for the student’s qualified tuition and related expenses. (Reg § 1.25A-1(f))   

If a student is required to pay a fee (such as a comprehensive or a bundled fee) to an eligible educational institution that combines charges for qualified tuition and related expenses with charges for personal expenses, the portion of the fee that is allocable to personal expenses is not included in qualified tuition and related expenses. The determination of what portion of the fee relates to qualified tuition and related expenses and what portion relates to personal expenses must be made by the institution using a reasonable method of allocation. (Reg. § 1.25A-2(d)(4))

If qualified tuition and related expenses are paid by the taxpayer during one tax year for an academic period that begins during the first three months after that tax year, that academic period is treated as beginning during the tax year in which the payment is made. In other words, if qualified tuition and related expenses are paid during one tax year for an academic period that begins during the first three months of the taxpayer's next tax year (i.e., in January, February, or March of the next tax year for calendar year taxpayers), an education credit is allowed with respect to the qualified tuition and related expenses only in the tax year in which the expenses are paid. (Reg § 1.25A-5(e)(2)(i); Terrell, TC Memo. 2016-85, Dec. 60,599(M))

CAUTION: The opposite is not true. Tuition payments made in one year for the next year cannot be credited to the next year because of the cash basis taxpayer rules (McCarville, TC Summary Opinion 2016-14). This is a mistake your clients can easily make.

Example - Prepayment Rule - Alan, who is a calendar year taxpayer and not a dependent of another taxpayer, enrolls full-time at College Z, with the Spring 2022 his first semester of attendance.  He continues at College Z through the Spring 2023 semester.  The following recaps his tuition payments during that period:

He may claim an education tax credit on his 2023 return with respect to the $1,000 he paid to College Z on Dec. 15, 2022 for the 2023 spring semester.  Alan may claim an education credit on his 2023 return with respect to the $12,000 he paid to College Z during 2023 ($4,000 + $7,000 + $1,000).  On his 2024 return, he may claim an education credit with respect to the $6,000 he paid to College Z on Feb. 15, 2024. (Reg 1.25A-5(e)(2)(ii))

Qualified tuition and related expenses do not include expenses that relate to any course of instruction or other education that involves sports, games, hobbies, or any noncredit course, unless the course or other education is part of the student's degree program, or in the case of the Lifetime Learning Credit, the student takes the course to acquire or improve job skills.  (Reg. § 1.25A-2(d)(5))

For purposes of the AOTC for at least one academic period during the year, the student must be enrolled for at least half of the normal full-time workload for his course of study. (Code Sec. 25A(b)(3)(B)) Form 1098-T, Tuition Statement, has a check box for the institution to indicate if the student was a half-time student.

For education credit purposes, qualified tuition must be reduced by tax-free scholarship amounts (including fellowships) excluded from income under Code Sec. 117 except to the extent, by the terms of the scholarship, it may (or must) be applied to room and board, in which case it is reported as taxable income if the student is required to file a tax return. (Reg. § 1.25A-5(c)(3))

The use of scholarship funds depends upon the terms of the scholarship. If the scholarship specifies it must be used towards tuition and expenses, then the scholarship is non-taxable and must reduce expenses that qualify for the education credits. If the scholarship species it is for room and board, then it must be used for room and board and is therefore taxable income. Where the funds can be used for any education purpose (discretionary), the use of the funds can be allocated among the educational expenses that provides the best overall tax benefits.

Federal student aid, including Pell Grants, can be used to cover a variety of costs, generally including tuition and fees normally assessed; books, supplies, transportation, and miscellaneous personal expenses; and living expenses such as room and board.

Payments to vets under the GI Bill for tuition and allowances is treated as support provided by the government when determining who pays over half of a student’s support. (2021 Pub 17 page 36)

Being able to allocate scholarships where the terms permit provides a significant strategy for maximizing the education credits. Consider the following:

Observation: If the parent(s) claim the student as a dependent, the parent(s) get the education credit, but the taxable scholarship amount is included in the student’s income, and since it is considered earned income, it is taxed at the student’s tax rate.

Making this allocation can become complicated since one must take into consideration the benefit of the education credit versus any tax to the student as a result of treating some portion of the scholarship amount as taxable.

By using the worksheet and allocating the scholarship between taxable and non-taxable income, the credit can be increased by $1,000 to $2,500 ((100% x $2000) + (25% x $2000)). However, the portion of the scholarship treated as taxable is taxable to the student, and in our example increases the student’s tax by $300, resulting in a net tax benefit of $700.

Scholarship or fellowship grants are taxable to the recipient if they are paid for teaching, research, or other services as a condition for receiving the grant, unless the payments are received under:

When part of the scholarship is taxable because it was payment for services, i.e., wages, the scholarship provider should issue a Form W-2 for the taxable amount. It is possible that this amount may also be included in the Box 5 (scholarships or grants) amount on Form 1098-T. Therefore, an analysis of the make-up of the Box 5 amount must be performed to ensure that there isn’t duplicate reporting of income.

Where an outside company agrees to collect tuition payments over a period of time (usually 10 months) and remits the payments to the educational institution on a predetermined schedule, the date of the payment for purposes of computing the education credit is determined as follows:

Form 1098-T Mandatory - A taxpayer is not allowed to claim the AOTC, the Lifetime Learning credit or, for years before 2021, the higher education tuition deduction, unless the taxpayer has received a Form 1098-T from the educational institution (Trade Act Sec 804(a)(1)). Thus, taxpayers won’t be able to file their returns on which they claim education tax benefits until they have received the Form 1098-T.

An eligible educational institution will send the student a Form 1098-T, Tuition Statement, generally by January 31 of the year following the year of attendance. The 1098-T also provides other information, such as adjustments made for prior years; the amount of scholarships or grants, reimbursements, or refunds; and whether the student was enrolled at least half-time or was a graduate student.

Missing 1098-T - Many educational institutions do not mail the form, but rather make the form available to the student online. If a student claims not to have received the form, have them double check their online account with the school.

1098-T Received by a Dependent  - 1098-Ts received by a dependent of the taxpayer are treated as received by the taxpayer (Trade Act Sec 804(a)(2)).

Expenses Not Included on the 1098-T - A taxpayer that substantiates payment of qualified tuition and related expenses that are not reported on Form 1098–T, may include those expenses in computing the amount of the education tax credit allowable for the taxable year. (Prop Reg 1.25A-1(f), NPRM REG-131418-14))

A taxpayer can claim an AOTC or LLC for a tax year and exclude from gross income amounts distributed (both the principal and the earnings portion) from a Coverdell Education Account for the same student, as long as the distribution is not used for the same educational expenses for which a credit was claimed.

Prior to the kiddie tax age being increased to include full time students through age 23, a commonly used tax strategy was to gift appreciated stock to a child and then have the child sell the stock at a lower tax rate and use the funds to pay for the child’s education. Since there is no longer any tax benefit to gifting appreciated stock to a full- time student under 24 to pay for education, what if the grandparents or other trusted relative or friend are in a lower tax bracket and....

The child's parents gift each grandparent or sets of grandparents enough appreciated stock that when sold would yield an after-tax amount that the grandparent in turn uses to pay the child's tuition?