Q. This distribution is meant to cover scholarship money my son received (not qualified expenses). Will there be an issue if we report the distribution processed on Jan 2, 2024, on our son's 2023 returns (the check written to him)?
A. No. More accurately, probably not. As explained above, we don't know, for sure, what the IRS's attitude is on this timing issue. Your son is more likely to hear form the IRS for not reporting the distribution on his 2024 return, because that is the year for which the 1099-Q will be issued. Even then, it's unlikely and easily explained, particularly since you can point out that it was reported on his 2023 return.
Be forewarned, this can get a little tricky, entering it into TurboTax. Be sur you enter the 529 distribution (at the 1099-Q screen even though you did not actually get a 1099-Q), before you enter the 1098-T. TT needs to prepare form 5329 to claim the penalty exception.
Another option is for him to declare some of the scholarship as taxable income, so that the 529 distribution (or some of it) can be tax free. Non qualified 529 distributions are unearned income.
Taxable scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $13,850 filing requirement (2023) and the dependent standard deduction calculation (earned income + $400, up to $13,850). It is not earned income for the kiddie tax and most other purposes (e.g. AOTC).
Q. Can he declare those as income in 2023 to avail of AOTC?
A. No. Neither scholarships or 529 distributions are "earned income" for purposes of the AOTC.
A full time unmarried student, under age 24, even if you don't qualify as a dependent, is only eligible for the refundable portion of the American Opportunity Credit if more than half his support comes from his own earned income. You cannot be supporting yourself on parental support, 529 plans or student loans & grants. It is usually best if the parent claims that credit.
