The Quirk in the IRS’s Tuition-Reporting Rules

SMITH BRAIN TRUST – College-tuition-paying tax filers should be extra careful when claiming that tax credit – at least for one more year. In the following piece, lecturer Samuel Handwerger at the University of Maryland's Robert H. Smith School of Business, with MS in Accounting student David Hao Li, give the backstory to the IRS permitting higher education institutions to report tuition as "charged" instead of "collected"  at the expense of tax filers who can only claim tuition as "paid."

When the IRS tries to be user-friendly, things can backfire. Perhaps you can call it the law of unintended consequences or a case of something not well thought out.

Here's what happened. Congress passes a tax law allowing for students taking accredited coursework past high school to get a tax break. It's an economically good idea – give an incentive to boost educating the workforce and the overall economy grows ... ask any economist. Congress, therefore, allows for a tax credit off your tax bill based on a percentage of your tuition costs up to a certain dollar limit and with limitations on how much income you earn. That started in 1997.

To help monitor the tax credit, Congress passed a law instituting Form 1098-T, whereby the school reports the tuition costs for the year to both the student and the IRS. 

The problem begins when the IRS tries to be accommodating to university accounting systems. Those systems invariably record tuition as it is charged as opposed to when paid. Whereas the first reporting forms required both the amount of tuition charged and tuition paid, the schools cried because the burden of having to report actual tuition paid wasn't easily accomplished with their databases. A friendly IRS steps in and allows the schools to report either tuition charged or tuition actually paid...for the year in question. That was back in 2001. 

Taxpayers, on the other hand, are only allowed to take the tax credit based on tuition paid, in the year actually paid, and not when in the year billed if different. Taxpayers report their tax matters on a cash basis of accounting. Cash must change hands to make the tax event official and allow for the credit. So for schools reporting only on tuition charged, that information is not relevant to the taxpayer and is not something the IRS can use to match to tax returns filed...fairly useless information.

This set the stage for millions of  cases of taxpayer fraud per year where bogus tuition refund credits are claimed. Since the IRS does not have a tracking system that works, the fraud mounts into the billions year-after-year, for example $3.2 billion in 2011 and $5.6 billion in 2012.

This also set the stage for naïve taxpayers to mistakenly claim the credit based on the Form 1098-T's reported billed tuition amount, not the amount actually paid, where the amount paid is the only amount for which they can claim the credit. That cash payment that would allow for the credit often came either before or after the year of the billing. So the inevitable happens. The IRS audits several taxpayers and denies their tax credit since they used the wrong number. 

The IRS recently acknowledged this dysfunction and Congress has mandated that colleges only report tuition paid, effective in 2017 (for the 2016 school year).  The story should end here, but not when the IRS is involved. The schools complained that this change asked of them is too speedy, and the IRS delayed the change until next year. Long live the IRS.

Bottom Line: Taxpayers should carefully claim their tuition credit based on tuition actually paid and when paid. They cannot rely on this information from the reporting Forms 1098-T and should check their own payment records.  

Samuel Handwerger is a full-time lecturer in the Smith School's accounting and information assurance department.