Article Highlights:

  • American Opportunity Tax Credit
  • Lifetime Learning Credit
  • Who Gets the Credit?
  • Qualified Tuition and Related Expenses
  • Eligible Educational Institutions
  • Form 1098-T
  • Scholarships
  • Tax Fraud

As with everything taxes, the devil is in the details, and that includes the education tax credits, which come in two types with some different rules for each. Many people think the credits are for sending their children to college, which is true, but the credits are also available to you and your spouse (if you are married) as well as to your dependents. So even taxpayers attending school part-time may qualify for a tax credit.

American Opportunity Tax Credit (AOTC) – The AOTC provides a credit of up to $2,500 per year per eligible student. Generally, tax credits are non-refundable, meaning they can only be used to offset any tax liability the taxpayer may have for the year. However, up to 40% of the AOTC is refundable, even when the taxpayer has no tax liability. Thus, it can result in a refund of as much as $1,000 (40% of $2,500).

The credit amount is 100% of the first $2,000 of tuition and related expenses plus 25% of the next $2,000 of qualifying expenses. However, the AOTC is only allowed for four tax years and only for the first four years of post-secondary education. The student must be enrolled at least half-time in a program leading to a degree, certificate, or other recognized educational credential for at least one academic period beginning in the tax year in which the credit is claimed.

This credit phases out for joint-filing taxpayers with modified adjusted gross income between $160,000 and $180,000, and between $80,000 and $90,000 for others. The credit is not allowed for married taxpayers using the filing status of married filing separately.

Lifetime Learning Credit (LLC) ‒ The LLC is a non-refundable credit worth up to $2,000 per year, and there is no limit on the number of years that the LLC can be claimed. Unlike the AOTC, there is no “half-time student” requirement, and single courses can qualify. The credit is 20% of the costs of tuition and related expenses. However, while the AOTC is determined on a per student basis, the LLC is based upon the tax family’s qualified education expenses for the year. If a student qualifies for the more beneficial AOTC, that student’s expenses cannot also be used for the LLC.

Like the AOTC, this credit phases out for higher-income taxpayers, but unlike the AOTC, the phaseout income levels are annually adjusted for inflation. For 2019, the LLC phases out for joint filing taxpayers with modified adjusted gross income between $116,000 and $136,000, and between $58,000 and $68,000 for others. The credit is not allowed for taxpayers who file married filing separate returns.

Who Gets the Credit? – As you would expect, the credit for dependents attending college or the taxpayer (and spouse, if any) attending college will be claimed on the taxpayer’s tax return. You may qualify for this credit even if you did not pay the tuition. If a third party (someone other than the taxpayer or a claimed dependent) directly makes a payment to an eligible educational institution for a student’s qualified tuition and related expenses, then the student would be treated as having received the payment from the third party and, in turn, as paying the qualified tuition and related expenses. Furthermore, qualified tuition and related expenses paid by a student would be treated as being paid by the taxpayer if the taxpayer claims the student as a dependent.

Example: If one divorced parent pays qualified tuition to a college for a child but the other parent has custody of the child (and is eligible to claim the child as a dependent), then the custodial parent is treated as having directly paid the tuition to the college and would get the credit.

Example: If a grandparent, or someone else, pays the qualified tuition directly to the institution, then the parents, assuming they claim the student as a dependent, would be the ones qualified to claim the education credit. This would also apply if the tuition was paid for the taxpayer or spouse. This makes for some interesting tax planning since the tuition paid directly to an educational institution is also excluded for gift reporting or gift tax consequences, allowing individuals who wish to make gifts above the $15,000 per year per recipient limit to pay the tuition for a non-dependent child or grandchild and avoid any gift tax complications, while at the same time providing the education credit.

Qualified Tuition and Related Expenses – Unfortunately, recent law changes affecting qualified expenses only applied to the AOTC, creating another difference between the two credits.

  • AOTC – Qualified expenses include tuition, books, supplies, and equipment required for enrollment or attendance at an eligible institution. For this purpose, “required for enrollment or attendance” means that the course materials are needed for “meaningful attendance or enrollment” in a course of study, whether or not the materials are purchased from the institution or an outside vendor. A frequent question is whether a computer qualifies as an AOTC expense. The IRS has indicated a computer does qualify if it is needed for attendance at the educational institution. Generally, in this day and age, a computer is necessary.  
  • LLC – Qualified expenses include tuition and amounts paid for books, supplies, and equipment, but only if these items are purchased from the educational institution as a condition of attendance.  

Eligible Educational Institutions – 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. This includes most colleges and universities. Vocational schools or other post-secondary schools may also qualify. If you aren’t sure if the student’s school is eligible, ask the school if it is an eligible educational institution. This requirement will rule out foreign educational institutions.

Special Tuition Prepayment Rule – A special rule allows the tuition for an academic period that begins in the first three months of the next year to be paid in advance; thus, it increases the amount of tuition qualifying for the credit in the year when the tuition is paid. This allows for planning of when to make tuition payments to maximize credits, especially in the first partial calendar year.

Tax Tip: Since the American Opportunity credit is only allowed in the first four tax years (calendar years for nearly all individuals) for each eligible student, taxpayers may benefit from prepaying the education expenses for an academic period beginning in the first three months of the next year. This is especially important when you consider that most students enter college in the last half of the first tax year and qualify for the credit with only half a year’s expenses in the first year. Working out a payment plan in which the tuition is prepaid under the three-month rule for each of the academic years would more evenly spread the tuition over the four years.

Form 1098-T ‒ In most cases, you (or the student) should receive Form 1098-T, Tuition Statement, from the school reporting qualifying expenses to the IRS and to you. The amount shown on the form will be the amount paid to the school for the student’s qualifying tuition and related expenses, not reduced by scholarships or grants. Therefore, the amount shown on the form in box 1 may be different from the amount eligible for the credit and may not be the amount you actually paid. You can only claim an education credit for the qualifying tuition and related expenses that you paid in that tax year. As discussed earlier in the Tax Tip, a provision allows the tuition for the first three months of the next year to be prepaid and deducted on the tax return for the year of payment. However, any prepaid tuition cannot be deducted in the subsequent year.

Scholarships – For education credit purposes, qualified tuition must be reduced by tax-free scholarship amounts (including fellowships) that are excluded from income.

Tax Fraud – The education credits are frequent targets for tax fraud, especially the AOTC, because a portion of it is refundable. So, the IRS has integrity provisions in place, including (1) that a taxpayer cannot amend a prior year return in which the individual qualifying for the credit did not have a taxpayer identification number (TIN) when the original return was filed and (2) that the employer identification number (EIN) of the educational institution must be included on Form 8863, which is the IRS form used to claim the credit. The EIN is included as part of the information on the Form 1098-T that the school issues to you.

In addition, paid tax preparers are subject to a monetary penalty if they do not abide by certain due diligence requirements and complete and submit the due diligence worksheet when filing a return.

As you can see, several nuances associated with the education credits must be considered. Please call this office if you need assistance with education planning or want more information on how the education tax credits apply to your particular circumstances.