Under which conditions are scholarships and fellowships considered taxable income?

Scholarships and fellowships can be regarded as taxable income under specific conditions, primarily associated with the relationship between the use of the funds and the characteristics of the recipient.

When analyzing the option that is noted as the correct answer, it is essential to recognize that only those scholarships and fellowships that require recipients to perform services (like working or teaching) or that are granted to non-degree candidates can lead to taxable income. In general, scholarships that cover tuition and fees, which are paid directly to educational institutions, remain non-taxable, especially when the recipient is a degree candidate.

In contrast, stipends or funds provided for living expenses, as well as scholarships given to non-degree candidates, can be subject to taxation. Therefore, when the funds are connected to a W-2, which represents earned income, it indicates that the recipient may have formal employment or an obligation to fulfill that could also qualify the scholarship as taxable.

This option accurately acknowledges that taxation on scholarships is nuanced and depends on the context of how the funds are utilized and the recipient's status. The determination between taxable and non-taxable scholarships is vital for tax preparation, as it impacts the overall income reporting for the individual taxpayer.