A primer on the Hope and Lifetime Learning Credits.

The Taxpayer Relief Act of 1997 (TRA '97) added Sec. 25A, providing the Hope

Scholarship and Lifetime Learning Credits, to foster higher education. Proposed regulations explaining these credits (with many helpful examples) were released for public comment on Jan. 6, 1999.

Hope Scholarship Credit 

Beginning Jan. 1, 1998, qualifying taxpayers may claim the Hope Scholarship Credit against their Federal income tax liability. The Hope Credit is a nonrefundable credit for "qualified tuition and related expenses" of each eligible student in a taxpayer's family (the taxpayer, the taxpayer's spouse or an eligible dependent), for whom the taxpayer claims a dependency exemption under Sec. 151 (Sec. 25A(f)).

The maximum credit per student per year is $1,500 for qualifying out-of-pocket expenses, indexed for inflation in tax years beginning after 2001 (Prop. Regs. Sec. 1.25A-3(a)(2)).

Income Limits

Modified adjusted gross income (AGI), the starting point in determining the phaseout, is the sum of the taxpayer's AGI plus any amount excluded under Sec. 911,931 or 933 (income earned abroad and income from certain U.S. possessions or Puerto Rico). The credit is phased out ratably for taxpayers with modified AGI between $40,000 and $50,000 ($80,000 to $100,000 for joint filers). For tax years beginning after 2001, these phaseout thresholds will be indexed for inflation.

The amount of the reduction is computed as Hope Credit + Lifetime Learning Credit x [(Modified AGI -- $40,000)/$10,000]. (Joint filers replace $80,000 for $40,000 and $20,000 for $10,000 in this formula).

Who May Claim the Credit?

Expenses must be incurred for the taxpayer, his spouse and eligible dependents (Sec. 25A(f)(1)). A parent may claim the credit for his unmarried child if the parent supplies more than half the child's support for the tax year and the child is under age 19 (or is a full-time student under age 24). If a parent claims a child as a dependent for the tax year, only the parent may claim the credit, even if the child pays for the qualifying expenses (Prop. Regs. Sec. 1.25A-5(g)). If an eligible taxpayer does not claim the credit, only the child may claim the credit (Prop. Regs. Sec. 1.25A-1(g)). Payments of qualifying expenses made directly to the educational institution by a third party (such as a grandparent) are deemed paid by the student (Prop. Regs. Sec. 1.25A-5(a)) and, thus, may be claimed by the parent or the child, as permitted under the above rules. A divorced parent not entitled to claim the dependency deduction is also treated as a third party. Thus, direct payments of qualified education expenses made by a noncustodial parent are deemed paid by the student, and the credit may be claimed by the custodial parent (or by the student, if the custodial parent does not claim the credit); see the example in Prop. Regs. Sec. 1.25A-5(b)(2)).

Who Is an Eligible Student?

The student must meet all of the following tests for the Hope Credit (Prop. Regs. Sec. 1.25A-3(d)(1)):

1. Degree: For at least one "academic period" (e.g., a semester, trimester or quarter) during the tax year, the student is enrolled at an eligible educational institution in a program leading to a postsecondary degree, certificate or other recognized credential;

2. Workload: For at least one academic period in the tax year, the student is enrolled at least half-time for the course of study the student is pursuing (meeting the standards of both the eligible institution and the Department of Education, under the Higher Education Act of 1965).

3. Year of Study: As of the beginning of the tax year, the student has not yet completed the first two years of postsecondary education at an eligible institution (disregarding credits awarded based on proficiency examinations).

4. Felony Drug Conviction Restriction: The student has not been convicted of a felony drug offense.

Based on the Committee Reports to Sec. 25A, an eligible student may be enrolled at, and claim expenses for, a study abroad program if the credits earned at the foreign institution are approved for credit at the eligible institution in which the student is enrolled.

The credit is generally not allowed for nonresident aliens (unless they elect to be taxed as U.S. residents under Sec. 6013(g) or (h)) and married filing separate taxpayers (Sec. 25A(g)(7) and (6); Prop. Regs. Sec. 1.25A-1 (i) and (h)).

What Is an Eligible Education Institution?

To qualify as an eligible educational institution, the college, university or vocational school, or other postsecondary educational institution, must be an accredited public, nonprofit and proprietary postsecondary institution, and eligible to participate in a Federal financial aid program under Title IV of the Higher Education Act of 1965 (20 USC 1088) (Sec. 25A(f)(2); Prop. Regs. Sec. 1.25A-2(b)).

What Are Qualified Tuition and Related Expenses?

Creditable tuition and fees are payments required for enrollment or attendance at an eligible institution (Prop. Regs. Sec. 1.25A-2(d)). "Comprehensive fees" (including qualifying and nonqualifying expenses) must be allocated by the educational institution based on a reasonable method. Taxpayers should ask the institution for an analysis that differentiates the qualified tuition and related expenses from personal expenses such as room and board (Prop. Regs. Sec. 1.25A-2(d)(4)).

Only out-of-pocket expenses qualify for the credit, including loans, gifts, bequests, devises or inheritances (defined in Sec. 102(a)) and savings from a qualified state tuition program. Items excluded from income do not qualify, such as tax-free scholarships and grants (e.g., a Pell Grant, a veterans' or member of the armed forces' educational assistance allowance), tax-free distributions from an Education individual retirement account (IRA) excluded under Sec. 530(d)(2) and tax-free employer-provided educational assistance excluded under Sec. 127. Likewise, expenses for which a deduction is claimed (e.g., under Sec. 162) do not qualify (Sec. 25A(e)(2), (g)(2) and (g)(5); Prop. Regs. Sec. 1.25A-5(c)).

Refunds of qualified tuition and related expenses (Prop. Regs. Sec. 1.25A-5(f)) must either:

1. Reduce qualified expenses that may be claimed if the refund is received in either:

* The same year as the payment; or

* The year after the payment, but prior to the filing of the return on which the credit is claimed; or

2. Trigger recapture of the credit, if the refund is received after the credit has already been claimed for a previous year.

When and How to Claim the Credits

Taxpayers can use Form 8863, Education Credits (Hope and Lifetime Learning Credits), to claim credits, attaching it to a timely filed Federal income tax return (including extensions). A credit can be claimed for payments made covering an academic period beginning in the same calendar year in which the payments are made, as well as payments made during the current tax year for an academic period beginning in the first quarter of the following calendar year (Sec. 25A(g)(4); Prop. Regs. Sec. 1.25A-3(e)).

The parent must include the student's name and social security number (TIN) on the return for the year the credit is taken (Sec. 25A(g)(1)). Assessments due to omission of a correct TIN are governed by Sec. 6213(b) and (g)(2)(J); see Prop. Regs. Sec. 1.25A-1(f).

Lifetime Learning Credit

Expenses paid after June 30, 1998 for education furnished in academic periods beginning after that date, may be eligible for a nonrefundable Lifetime Learning Credit against a taxpayer's Federal income taxes, if incurred for qualified tuition and related expenses of a qualifying student enrolled in an eligible educational institution.

The maximum credit is $1,000 (20% of the first $5,000 of out-of-pocket qualified tuition and related expenses) per family per year through 2002, increasing to $2,000 per family per year (20% of the first $10,000 of qualified expenses), not indexed for inflation (Sec. 25A(c)(1)).

Some of the requirements and definitions are the same for the Hope Credit and the Lifetime Learning Credit, with the following notable exceptions:

* No requirement to be enrolled at least half time for at least one academic period. The Lifetime Learning Credit may be claimed for students taking one or more courses to acquire or improve their job skills (Sec. 25A(c)(2)(B); Prop. Regs. Sec. 1.25A-4(c));

* The education need not be for only the first two years of undergraduate education. The Lifetime Learning Credit may be taken for graduate or professional degree courses;

* The maximum Lifetime Learning Credit does not vary with the number of students in the family for whom qualifying expenses were incurred; it is based on total qualifying expenses of all eligible family members incurred in the tax year;

* The Lifetime Learning Credit may be claimed for an unlimited number of tax years (Prop. Regs. Sec. 1.25A-4(b));

* No reference is made for claiming the Lifetime Learning Credit for expenses incurred in study abroad programs; and

* The amount of the Hope Credit will be indexed for inflation, while the Lifetime Learning Credit will not.

Coordination

A taxpayer must elect the Hope Credit, the Lifetime Learning Credit or the Education IRA for the same student's expenses in a single tax year (Sec. 25A(e) and (c)(2)(A); Prop. Regs. Sec. 1.25A-1 (b) and (e)). However, there is some flexibility:

* A parent may elect to take the Hope Credit for one child and the Lifetime Learning Credit or tax-free Education IRA for another child;

* A student can elect to waive the tax-free treatment of the Education IRA and take either credit for that tax year; and,

* The decision of which benefit to elect is made on a year-by-year basis for each qualifying student.

Tax Planning Opportunities

1. Use the prepayment rules to your advantage:

* Students entering college late in the year who will not incur sufficient qualified tuition expenses to use the maximum $1,500 for year 1 can prepay their second-semester tuition (prior to Dec. 31 of year 1) to qualify for the maximum Hope Credit in year 1.

* If a taxpayer's modified AGI is expected to fluctuate significantly from year to year, the allowable credit can be maximized by timing the payment (to the extent permitted) of qualified expenses in the year the taxpayer expects to fall below the AGI phase-out limitations.

2. Do the math: If expenses qualify for both the Hope and Lifetime Learning credits, determine which to claim on a year-by-year basis to maximize the total allowable credits.

3. Loan proceeds are eligible: Tuition expenses paid with loan proceeds are eligible for the credit (Prop. Regs. Sec. 1.25A-5(e)(3)).

4. Divorced parents (to ensure that one parent gets the credit):

* The court-approved divorce decree should state that the parent required to pay the student's tuition also claims the dependency exemption; or

* If no mention is made in the support agreement, the credit may be lost unless the noncustodial parent makes the payment of the qualified education expenses directly to the qualified education institution. The direct payment would be attributed to the student and the custodial parent would be in a position to claim the credit (the student could claim the credit if the custodial parent does not) (Sec. 25A(g)(3); Prop. Regs. Sec. 1.25A-5(b)(2)).

5. Savings from qualified state tuition program allowed: Expenses paid from a qualified state tuition program are eligible for the credit.

6. Work around the phaseout:

* If high-income parents cannot claim the credit, a student with sufficient taxable income can claim the credit on his own tax return. The student can generate taxable income from part-time jobs (earned in a family business or otherwise) and investment income (earned on gifts or other savings).

* Payments made by a third party (e.g., a grandparent) can be claimed by the student if the third party makes the payment directly to the eligible educational institution (Prop. Regs. Sec. 1.25A-5(a)) and the parents do not claim the dependency exemption for that student.

7. Study abroad credits: Credits earned in a study abroad program that are creditable at an eligible educational institution are acceptable for the Hope Scholarship Credit. Arguably, this concept may also apply to credits earned abroad for the Lifetime Learning Credit; however, this has not been specifically sanctioned.

Information Reporting

The qualified educational institution must make an annual information report (Sec. 6050S(a)) on new Form 1098-T, Tuition Payments Statement. The statements are due Jan. 31 (for the recipient) and Feb. 28 for the IRS copy.

The reporting burden was eased for 1998. The 1998 Form 1098-T (for reporting both credits) contains the following fields: the filer's name and address, the student's TIN, name and address and check-off as to whether the student is half-time or a graduate student. Until regulations are issued, penalties will not be imposed if a good-faith effort was made to comply with Notice 97-73. Notice 98-46 extends the requirements of Notice 97-73 for 1999. Notice 98-59 relieves educational institutions from filing information returns for nondegree students and nonresident aliens, unless requested by the student to provide the information.

Additional information will be required to be reported in future years (e.g., name, address and TIN of the individual claiming the credit, and the amount of the qualifying expenses paid during the reporting year), as described in Sec. 6050S(b)(2).

FROM ESTELLE E. MILLER, CPA, NEW YORK, NY