The first couple of requirements for scholarships, fellowships or grants to be tax-free are easy: First and foremost, the student must be working toward a degree. In addition, the student must be studying at an educational institution that the IRS considers "qualified." The school must be an accredited one that can either grant recognized bachelor's degrees or higher, or prepare students for a job in a "recognized occupation." The IRS specifies that a school must have "regular" faculty and curriculum and must "normally" have students who physically attend classes.
If you pass those tests, all or part of your financial aid may be tax-free. The details of the next requirement can be trickier. A scholarship, fellowship or grant that otherwise meets the rules should be tax free as long as the money is used for what the IRS terms "qualified educational expenses."
Qualified expenses include any required tuition and fees, as well as other expenses like books, supplies and equipment that are required of all students in a certain course.
Essentially, any scholarship, fellowship or grant money used for anything else is taxable. That includes money used for travel, room and board, research and clerical help. Publication 970 and the IRS helpline offer the same advice: Those are the rules, and there don't seem to be exceptions. If part of an athlete's full scholarship pays for room and board, for example, that part is taxable. If part of a Fulbright grant goes to pay for travel, room or board, that part is taxable. If a student on a Fulbright grant isn't working toward a degree, the entire scholarship amount is taxable [source: Fulbright].
The burden of keeping track of what part of a scholarship, fellowship or grant is taxable falls on the student. Many grant programs, such as those run by individual states, give money for tuition or other qualified expenses only, so that none of the money will be taxable.
Schools are required to issue W-2 forms for paid assistantships and other campus jobs, but they are not required to report scholarship money [source: Newaccountant]. Many college financial-aid offices advise students to keep receipts documenting the money they spend on tuition, fees and other qualified educational expenses. They should deduct that amount from the amount of their scholarship, fellowship or grant, and report any extra money as taxable income.
The most important thing to remember is to leave nothing to chance. Questions about whether your financial aid is taxable? Ask your tax preparer or accountant, or go directly to the IRS.