Winning a Fight with the IRS

I’m very, very excited about the content I have to share with you today. The story comes from someone who found EPF while searching for resources regarding grad student taxes and how to argue with the IRS. After emailing back and forth a few times about how to approach her problem, she offered to share her research and work with you through EPF. I will refer to this reader as Amanda in this post. Thank you, Amanda, for sharing your story with the EPF community!

 

winning against IRS

 

In 2012, Amanda received an external fellowship. She received a 1099-MISC and reported the income on her 1040 that year in line 21.

 

All was fine until a few months ago, when Amanda received a letter from the IRS asking for several thousand dollars in back taxes and fines. The IRS claimed that she owed FICA taxes on the fellowship. She looked at the tax code and at a bunch of cases and constructed the argument and letter below. I hope Amanda’s research will also help put to bed some of the debates we have had on this topic in the past! (But remember that neither Amanda nor I are tax professionals or lawyers or anything like that, so please use this letter only for reference.)

 

To the Internal Revenue Service:

 

I have been asked to agree to changes to my tax return, primarily to the addition of a self-employment tax on the [$X] I received from [Fellowship Organization] and which I reported in line 21 as income from a scholarship or fellowship on a 1099-MISC. I do not agree to these changes. I do not owe a self-employment tax because I was not self-employed and instead was receiving a scholarship meant to help me complete my [degree].

 

According to Topic 554 on the IRS website, the self-employment tax applies “if you are a sole proprietor (including an independent contractor), a partner in a partnership (including a member of a multi-member limited liability company (LLC)), or are otherwise in business for yourself” (Attachment 1). However, I was not involved in a business relationship or partnership with [Fellowship Organization]. [Details about the terms of the fellowship with an attachment.]

 

According to Parker’s Tax Library, “a fellowship grant allow[s] the taxpayer to perform research and studies primarily to further his own education, training, and academic excellence and, thus, the grant [is] not compensation subject to self-employment tax” (Attachment 3). This has been well-established in the court case Spiegelman v. Commissioner, 102 T.C. 394 (1994), which reaffirmed that “[Scholarships and fellowship grants] do not constitute income from a trade or business and, hence, are not to be included in the recipient’s net earnings from self-employment for purposes of the Self-Employment Contributions Act. The terms ‘fellowship grant’ and ‘trade or business’ are inconsistent and mutually exclusive” (Attachment 4). The case also held that private fellowships are FICA exempt: “a scholarship or fellowship grant are not considered to be ‘wages’ for FICA and FUTA purposes, even though they may be otherwise taxable” (Attachment 4).

 

In conclusion, the [$X] was not compensation for any services or business that I performed for [Fellowship Organization], but instead was a fellowship grant intended to further my own education. It therefore does not meet the definition of “self-employment” under the IRS code. I would be happy to amend my return to clarify the situation better, but I am clearly not liable for the self-employment tax.

 

I urge you to contact me if you have any further questions.

 

Sincerely,

Amanda

 

What can we learn from Amanda’s research and example?

 

1) The IRS is both fallible and (can be) reasonable. They were wrong about Amanda’s 2012 taxes, but they did listen to her and it was all resolved without her having to pay any extra money.

 

2) The IRS code is a great reference, but so are the cases. Where the code is ambiguous, as it is for fellowships and FICA taxes, you can look for a relevant case.

 

3) You should report your fellowship and scholarship income in line 7 of the 1040 with “SCH” written next to it instead of following the instructions for the 1099-MISC. I don’t know this for sure, but I’d guess that the IRS wouldn’t have flagged Amanda’s return if the fellowship had been reported in line 7.

 

4) Fellowships are not subject to FICA even though they are subject to income tax. This comes directly out of the case Amanda referenced, Spiegelman v. Commissioner:

 

“Accordingly, even though part of a section 117 scholarship or fellowship grant must be included in the recipient’s gross income because of the limitations prescribed in [former] section 117(b)(2) of the Code, no part of the grant is subject to the tax on self-employment income imposed by section 1401 of the Code.”

 

Basically, there are not just two types of income you can be paid by another party, wages and self-employment. There is (at least) also the existence of a scholarship or fellowship, which is exempt from FICA taxes (both the employer and the employee side).

 

I want to personally thank Amada again for her research as she has confirmed for me that I do not owe FICA taxes on the income from my current fellowship. I think it’s easy to understand that grad students at universities do not owe FICA tax on their earnings because of the student exemption for wages. Postdocs and post-grad fellows, however, don’t have student exemptions. But if your pay is from a fellowship, it is not considered wages and is not subject to FICA, whether you are a student or not.

 

Have you ever disputed an IRS edit to your taxes, and did you win or lose? Have you ever received pay that you owed income tax on but not FICA?

 

photo modified from neal1973

 

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13 Responses to "Winning a Fight with the IRS"

  1. E 2 says:

    Well done, Amanda! What a concise and well-informed letter. Thanks to you and Emily for sharing.

    1. Emily says:

      Thanks for your comment!

  2. Fiby says:

    Yay! Go Amanda!

    Thankfully I’ve never had to dispute the IRS over anything. Good to hear about Amanda’s successful dispute though, I do have fellowship income. I do write SCH [$Fellowship amount] on line 7, so that should hopefully reduce my chances of getting flagged for not paying FICA tax.

    1. Emily says:

      I’m not positive that made the difference but it is the most correct way to report a fellowship. I know I reported in line 21 at first as well because I read the instructions for the 1099-MISC instead of Publication 970 and there are conflicting instructions.

  3. Nice Amanda, I have learned so many things and research about IRS. Thanks for sharing it with us, though I haven’t dealt with IRS but I am sure this info would really help me.
    Jayson @ Monster Piggy Bank recently posted..New House Update

    1. Emily says:

      Thanks, Jason.

  4. […] Winning a Fight with the IRS Evolving Personal Finance […]

  5. Harrison Russin says:

    Thank you for this post. I received a 1099-MISC for my grad school fellowship, and I’m very confused as to why. The tax code states rather clearly:

    (section 117) Scholarships. Do not use Form 1099-MISC to report scholarship or fellowship grants. Scholarship or fellowship grants that are taxable to the recipient because they are paid for teaching, research, or other services as a condition for receiving the grant are considered wages and must be reported on Form W-2. Other taxable scholarship or fellowship payments (to a degree or nondegree candidate) do not have to be reported by you to the IRS on any form. ​

    However, the HR department at my school won’t budge so I will have to follow these instructions…

    1. Emily says:

      Hi Harrison,

      Yes, the nuance in what you quoted is that W-2 pay is for teaching, research or other services, but a fellowship is an award and according to your funder and the IRS there is no “condition” for receiving it. It is typical – and perhaps unfortunate – for fellowship recipients who have income taxes withheld to receive a 1099-MISC with box 3 income at tax time.

      Emily

  6. amy says:

    our accountant does our taxes and he put fellowship income (not our only source of income) on Income line 21 on the 1040.
    he also writes this (not sure what it means, couldn’t look up the code myself)
    “fellowship income not subject SE tax per Rev Rul 37-60B”

    it’s been two years and so far so good! (we don’t get 1099 for it though, so maybe that helps too)

    1. Emily says:

      Hm, I’m not sure why your accountant would use line 21 if there is no 1099-MISC involved.

  7. Promise says:

    Hello,

    Thank you for taking the time to write about this topic, Emily. I’ve found your posts to be extremely helpful.

    Can you please clarify something? It sounds like you’re saying that you should report your fellowship and scholarship income on line 7 with “SCH” written next to it EVEN IF you receive a 1099-MISC. Is that correct?

    I’m also confused about tuition and fees paid directly to the university on my behalf. How and where do I report that information? Does it affect my tax liability and/or tax bracket?

    Thank you so much, again.

    1. Emily says:

      Yes, fellowships should be included in line 7 with “SCH” no matter how they are documented. Some people want to report 1099-MISC box 3 fellowships in line 21, which is OK but not ideal. Just be sure to report it once!

      You won’t pay tax on additional scholarships you receive (paid on your behalf, passing through your name) if they go toward qualified fees such as tuition. (Note that health insurance premiums are not a qualified fee.) In this case, you just add up the scholarships paid for you and subtract the qualified fees, and you should report the excess as income. If you receive a 1098-T from your university, that should help with this calculation.

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