Seeing how my own career includes lengthy stints as a tax CPA and as a college financing expert (Savingforcollege.com), it should come as no surprise that I am interested in ferreting out the tax and financial-aid consequences of winning a student business-plan competition.
And with so many student competitions just getting started for the 2010-2011 academic year, this issue can be of immediate concern.
If you enter and win a business plan competition, the general rule is that any cash prize, plus the value of non-cash prizes, must be reported by you as income on your federal income tax return. If you want proof for this conclusion, you can look to IRS Publication 525 Taxable and Nontaxable Income.
“But why isn’t it a tax-free scholarship?” you might ask.
Well, it could be, if the prize fits under the special exception for scholarships.
Here’s how the IRS describes the exception in Publication 970 Tax Benefits for Education: “If you win a scholarship as a prize in a contest, the scholarship is fully taxable unless you meet the requirements discussed earlier under Tax-Free Scholarships and Fellowships.”
There are two essential requirements. First, you must be a candidate for a degree at an eligible institution. Second, you must use the scholarship to pay for qualified education expenses. Publication 970 provides more details on what it means to be a candidate for a degree; which institutions are eligible institutions; and which types of expenses are qualified expenses. Suffice it to say that student-competitors at most business plan competitions who use their winnings to pay for tuition, mandatory fees, and required books, supplies, and equipment — but not for room and board or transportation — will meet these requirements.
But be careful what you wish for.
Taxable income can certainly be unpleasant, especially for 23-year-olds subject to the “kiddie tax.” But some students can absorb the taxable income without incurring a tax liability. The other notable consequence is that the income reported on this year’s return may impact next year’s financial aid award by increasing the student’s “expected family contribution.”
However, a tax-free scholarship can have a much bigger impact on financial aid. The federal aid formula requires a dollar-for-dollar offset for tax-free scholarships, as opposed to the partial impact of gross income. And most schools will do the same for their own, non-federal, aid awards.
So if you are a student, and you win a cash prize at your school’s business plan competition, you may actually have a choice: either voluntarily include it in gross income on your tax return, or treat it as a tax-free scholarship. You need to look closely at how either option will affect your financial aid package as well as your income tax liability.
The method by which the competition prize is paid can also make a difference. If the school does not pay you, but instead applies your winnings as a scholarship directly against your student tuition account, there is probably not much you can do about any financial-aid impact. This appears to be the case, for example, at Belmont University in Nashville where the rules for the student business plan competition have included the following statement:
Scholarships will be awarded for the current school year and may affect other financial aid. If you have questions about how it may impact your financial aid package, please contact Student Financial Services.
This can be contrasted with the MIT $100K Entrepreneurship Competition which pays its cash prizes directly to the individual or company winners:
The individual recipients of prize money will be responsible for the tax implications of their winnings….Note that prize payments are treated as income by MIT and the IRS, regardless of whether the payment is made to an individual or a company. Non-U.S. citizens are taxed on their prize money up front at a rate of 30%, which is withheld from their prize checks.
A quick survey of several of the student business plan competition websites suggests that many schools could do a better job of explaining the tax and financial-aid issues in their official rules.
Disclaimer: This article does not serve as and is not intended to be tax advice. Consult your own professional tax adviser. The same goes for financial aid.
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