Generally, a scholarship or fellowship grant is any amount paid to, allowed to, or for the benefit of someone to pursue study or research. A scholarship or fellowship grant may be in the form of a reduction in the amount the recipient owes to the University for tuition, room and board, or any other fee.
Only "qualified scholarships" may be excluded from income. Qualified scholarship amounts include tuition and fees required for the enrollment or attendance of a student at an educational institution, and required books, supplies, and equipment. Amounts received for room, board, travel, and incidental living expenses are not related expenses and are not excluded from gross income under the Internal Revenue Code. For non-degree candidates and postdoctoral fellows, the entire grant is included in the gross income of the recipient.
A scholarship or fellowship grant represents payment for services when the grantor requires the recipient to perform services in return for receiving the grant or to pursue studies, research, or other activities primarily for the benefit of the grantor. A scholarship or fellowship grant received on the condition of past, present, or future services by the recipient, or services that are subject to the direction or supervision of the grantor, also represents payment for services.
The IRS broadly defines a scholarship as "an amount paid or allowed to, or for the benefit of, a student, whether an undergraduate or graduate, to aid such individual in pursuing his studies" and fellowship as "an amount paid or allowed to, or for the benefit of, an individual to aid him in the pursuit of study or research."
The topics below will help you in paying scholarship and fellowship grants to nonresident foreign nationals.
Source of Payment--U.S. or Foreign
The first step in determining whether a scholarship, fellowship, or grant to a nonresident foreign national should be subject to taxes and reporting is to determine the source of the grant.
In general, scholarship, fellowships, and grants to nonresident foreign nationals from sources outside the United States are not taxable or reportable to the IRS. The source of the grant payment is determined by the "residence of the payor" not the location of the educational activity. Thus, a nonresident foreign national studying in the U.S. but receiving grant funds from a foreign source is not subject to tax withholding or IRS reporting on those funds, even if paid through an "intermediary agency." The IRS says there must be a "genuine agency relationship" between the intermediary and the payor of the grant.
Example: The scholarship grant payment is considered to be a foreign source if the foreign student's government contracts with a U.S. agency to administer the grant funds paid to their students in the U.S.
Scholarship, fellowship, and grant payments made by a U.S. payor to a nonresident foreign national studying outside the U.S. are also considered to be a "foreign source."
Qualified vs. Non-Qualified Scholarship Payments
Under IRS regulations, a "qualified scholarship" is one that pays "tuition and fees paid to enroll in, or to attend, an educational institution" or "fees, books, supplies, and equipment required for the courses at the educational institution." Qualified scholarships to nonresident foreign nationals are not subject to tax withholding and not IRS reportable.
Any portion of the scholarship, fellowship, or grant that does not directly pay for those items mentioned above is considered non-qualified and is included in the gross income of the recipient and subject to withholding. For non-degree candidates and postdoctoral research scholars, the entire grant is subject to withholding and reporting to the IRS if paid to a nonresident foreign national.
Scholarship/Fellowship vs. Prize/Award vs. Gift vs. Compensation
For nonresident aliens, there is an important difference between a scholarship or fellowship and a prize or award—the tax withholding rate. A prize or award is subject to a 30% federal tax withholding, whereas a scholarship or fellowship is generally taxed at 14%. The difference depends on the nature of the payment:
- If it is based on past accomplishment or activity, it is considered a prize or award.
- If it is made for future or continuing education activity (that doesn't required services), it is considered a scholarship or fellowship.
For federal tax purposes, a gift is characterized as "detached and disinterested generosity, motivated by affection, respect, admiration, or charity." In other words, a gift can be excluded from taxable scholarship/fellowship payment reporting. If, however, the payment qualifies under IRS rules as both a gift and a scholarship or fellowship, the payment will be subject to all the rules for scholarships and fellowships. Generally, the IRS considers it virtually impossible to argue that a payment to pursue educational activity should be treated as a gift for tax purposes. The only exception is if the payment was "provided by an individual to aid a relation, friend, or other individual in the pursuit of study or research if the grantor is motivated by family or philanthropic considerations." This exception applies only to grants made by individuals, not organizations.
The distinction between a scholarship or fellowship grant and compensation is quite important from a tax compliance perspective. Compensation paid to a nonresident foreign national is subject to either a 30% withholding rate, if paid for independent services, or at the graduated tax rates if paid to an employee. A scholarship or fellowship grant represents payment for services when the grantor requires the recipient to perform services in return for receiving the grant, or to pursue studies, research, or other activities primarily for the benefit of the grantor. A scholarship or fellowship grant received on the condition of past, present, or future services by the recipient, or services that are subject to the direction or supervision of the grantor, also represents payment for services.
Nonresident vs. Resident Foreign National Employee
For IRS purposes, the definitions of nonresident alien and resident alien are:
- Nonresident: A non-U.S. citizen who does not meet either the "green card" test or the "substantial presence" test described in IRS Publication 519, U.S. Tax Guide for Aliens.
- Resident: Meets either the "green card" or "substantial presence" test described in IRS Publication 519.
To determine residency for tax purposes, the international visitor or student should complete the substantial presence test.
Nonresident aliens are subject to federal tax withholding at either 30% or 14% on all non-qualified or taxable scholarship/fellowship payments made from a U.S. source. F-1 and J-1 visa classifications are subject to 14% withholding. All other visa classifications (such as H-1b) are subject to 30% withholding on their scholarship or fellowship payments. If the nonresident qualifies for a tax treaty exclusion and files the correct forms with Payroll Services, the payment will be exempted from tax withholding. Scholarship/fellowship payments to nonresident foreign nationals are reported to the IRS on Form 1042-S.
Resident foreign nationals for tax purposes are treated the same as U.S. citizens in respect to scholarship or fellowship payments: Non-qualified payments, though taxable and reportable to the IRS by the payee, are not subject to withholding and reporting by the payor (University). However, if the resident qualifies for tax treaty benefits and files the correct forms with Payroll Services, the scholarship or fellowship payment can be treated as exempt from taxation in the U.S. and reported to the IRS on Form 1042-S.
Here are brief descriptions of the green card test and the substantial presence test.
- Green Card Test: The foreign national employee is treated as a U.S. resident for tax purposes if the Immigration and Naturalization Service issues them lawful permanent residency ("green card") at any time during the calendar year. The permanent residence status remains in effect until it is either rescinded or judicially determined to be abandoned.
- Substantial Presence Test: The substantial presence test is composed of two parts—the 31-day test and the 183-day test. The foreign national employee must be present in the U.S. for at least 31 days during the calendar year, and 183 days during the three-year period that includes the current year and the two previous years. The person counts all days present in the current year, one-third of the days present in the previous year, and one-sixth of the days present in the second previous year. However, there are exceptions to the way the days are counted:
- F-1 and J-1 student visa holders are exempt from counting their first five calendar years in the U.S.
- J-1 scholars (or non-students) are exempt from counting days for two of the last six calendar years in the country.
For more information on resident foreign national employees, see Substantial Presence Test.
Tax Withholding, Tax Treaty Benefits, and IRS Reporting Requirements
All U.S. source non-qualified scholarship or fellowship payments made to a nonresident foreign national employee are subject to taxes and reporting to IRS. Taxes must generally be withheld at the 30% tax rate on all "fixed and determinable" U.S-source income payments made to nonresident foreign nationals, unless exempted under the Internal Revenue code or a tax treaty. However, foreign nonresidents on F-1, J-1, M-1, or Q visas are subject to only 14% withholding on the taxable portion of the scholarship or fellowship payments.
Many countries have entered into reciprocal agreements with the U.S. that allow foreign national employees to claim an exclusion from tax withholding under a tax treaty benefit. If the person qualifies for the treaty exclusion, they should file IRS Form W-8BEN with Payroll Services.
Form W-8 BEN is valid until December 31 of the third calendar year after the form was submitted. It is valid indefinitely as long as payments are made at least once a year. However, Form W-8BEN is invalid on the day any of the information in it ceases to be valid (such as when the person's treaty benefits expire). For more information on tax treaty benefits, see Claiming Tax Treaty Benefits, or see Tax Treaty Countries and Affidavits for a list of the countries that have entered into tax treaty agreements with the U.S.
All taxable scholarship or fellowship payments made to nonresident foreign national employees are required to be reported to the payee and to the IRS on Form 1042-S.
How Scholarship/Fellowship Grants Are Paid at the University
At the University of Minnesota, scholarship and fellowship payments are made in three ways:
- Non-service graduate fellowships paid in classes 9560, 9561, 9562, 9564, 9565, 9566, 9567, 9568, 9569, 9582, and 9583. These are paid to support the fellows in their course of study or research. These payments are made on a biweekly pay cycle through the normal payroll process. Contact your departmental HR/payroll administrator for details.
- Fellowship payments made to short-term visiting research scholars to defray their living expenses while at the University to perform independent research. These are paid through the PVC payment process. See Paying Nonresident Alien Contractors/Payees for more information on the PVC payment process.
- The process looks at the taxable credits posted to the student's accounts and totals the offset charges on the student's account. Based on the student's tax data in PeopleSoft, the process will determine if the student has a tax treaty or if the student has met any substantial presence qualifications. It then determines the applicable tax rate, totals taxes already posted to the student's account, and does a calculation to determine if there is additional tax due or if the amount of tax charged should be reduced. The data will automatically route to Payroll Services for IRS reporting. If the nonresident foreign national student is eligible for treaty benefits, the tax treaty forms must be submitted to Payroll Services before the payment is processed.