Hi Vanessa (and Janet),
I am facing a similar scenario -- a child on a full-ride scholarship, and I'd like to take advantage of the AOTC via the IRS-suggested way of allocating up to $4k in scholarship funds as income on my child's return (instead of allocating it towards the expense of tuition, which would make it tax-free), and then claim the $4k towards the AOTC on my own return. All of the IRS and other published examples are seemingly for non-full-ride scholarships, though many examples do indeed show scenarios where the scholarship exceeds qualified expenses (tuition, fees, books) by a considerable amount. I'm just not sure whether additional expenses need to be left "unspoken for" in order to shift the allocation around, nor whether those expenses need to all have been accounted for by the university. It isn't clear to me from your answer to the original poster (whose child appears to have earned a similarly large scholarship) whether the AOTC optimization strategy (which the IRS itself advocates for) can be applied in the setting of a full-scholarship, which results in no additional non-scholarship funds received by the university. The IRS publications on the topic state that the taxpayer can allocate the funds in a different manner than the university chose to, but they do not appear to clearly address whether there needs to be room left in the "unqualified expenses" bucket to execute this allocation. Given that the IRS also shows that payments made by a third party can be claimed by as payments made by the student (or parent), and acknowledges that the cost of attendance (COA) given by the university is just an estimate, and the 1098-T is just for guidance (a tax filer does not need to claim to have allocated their scholarship or grant funds in a manner consistent with the 1098-T reporting, as I understand it), it appears to me that the IRS guidance leaves room to take advantage of the AOTC even with a full-ride scholarship. However, I'm not an accountant, so I'd love to hear an expert weigh in on the topic.
Q. It appears to me that the IRS guidance leaves room to take advantage of the AOTC even with a full-ride scholarship?
A. Yes. You can do what you propose to do.
Q. I'm just not sure whether additional expenses need to be left "unspoken for" in order to shift the allocation around, nor whether those expenses need to all have been accounted for by the university?
A. You claim the tuition credit, or report scholarship income, based on your own financial records.
As you apparently know, There is a tax “loop hole” available, and the IRS encourages use of the loop hole. 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.
