Dependent got scholarships exceeding educational expenses - how to pay tax on that scholarship income

If that is her only income, she does not need to file a tax return.

You do not report his/her income on your return. If it has to be reported, at all, it goes on his own return. If your dependent child is under age 19 (or under 24 if a full time student), he or she must file a tax return for 2020 if he had any of the following:

1.          Total income (wages, salaries, taxable scholarship etc.) of more than $12,400 (2020).
2.          Unearned income (interest, dividends, capital gains, unemployment, taxable 529 distributions) of more than $1100.
3.          Unearned income over $350 and gross income of more than $1100
4.          Household employee income (e.g. baby sitting, lawn mowing) over $2100 ($12,400 if under age 18)
5.          Other self employment income over $432, including money on a form 1099-NEC

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There is a tax “loop hole” available. The student reports all his scholarship, up to the amount needed to claim the American Opportunity Credit (AOC), as income on his return. That way, the parents  (or himself, if he is not a dependent) can claim the tuition credit on their return. They can do this because that much tuition was no longer paid by "tax free" scholarship.  You cannot do this if the school’s billing statement specifically shows the scholarships being applied to tuition or if the conditions of the grant are that it be used to pay for qualified expenses.

Using an example: Student has $10,000 in box 5 of the 1098-T and $8000 in box 1. At first glance he/she has $2000 of taxable income and nobody can claim the American opportunity credit. But if she reports $6000 as income on her return, the parents can claim $4000 of qualified expenses on their return.

Books and computers are also qualifying expenses for the AOC. So, extending the example, the student had another $1000 in expenses for those course materials, paid out of pocket, she would only need to report $5000 of taxable scholarship income, instead of $6000.

eajcrawford,

You may have some homework to do here.  The first thing to do is download IRS Publication 970 (2020 Publication 970 (irs.gov)) and read up on the American Opportunity Credit. (Here I am assuming your dependent student is an undergraduate in their first four years at college.)   In particular, read up on page 16 and 17.

There are a few points to understand and/or consider:

(1) Yes, scholarship income, that is the excess of tax-free scholarships over qualified educational expenses, is income taxable to the student. 

(a) For the purposes of computing the dependent's standard deduction, it is considered earned income. 

(b) However, for the purposes of the dependent "Kiddie Tax", it is considered unearned income.

(2) When tax-free scholarships exceed qualified educational expenses, they are considered to have paid all the qualified expenses already, so you have no out-of-pocket qualified expenses to claim for the credit.

(3) The cited pages in publication 970, though, give you some potential wiggle room.  Depending upon the stipulations of the scholarship, specifically whether it can be applied against non-qualified expenses such as room and board or for that matter rock concert tickets, it can be beneficial to shift some or even all of the scholarship total from tax-free to taxable.  As soon as the residual tax-free portion is reduced below qualified educational expenses, there are now out-of-pocket qualified expenses that can be claimed for the educational credit.

How much to shift depends upon a number of factors and probably needs to be determined by trial-and-error.  In almost every case the first $2,000 thus shifted reduces your own taxes and also reduces the sum of your taxes and your dependent's taxes.  (Of course this assumes that there were at least $2,000 of such expenses to begin with.) Beyond that, you can try a variety of values up to $4,000 and see what gives the best result for the sum of your tax plus your student's tax.

One final tip: Not all qualified educational expenses are reported on Form 1098-T.  So do run through the actual info on pages 13 and 14 to add stuff like course textbooks to what appears on the 1098-T before figuring scholarship income.