WASHINGTON — A little-noticed provision in President Trump’s sprawling new tax law is treating middle- and low-income college students as if they are trust-fund babies, taxing sizable financial aid packages at a rate first established 33 years ago to prevent wealthy parents from funneling money to their children to lower their tax burdens.
Higher-education leaders are calling on Congress to fix the provision, which drastically raised the tax rate on so-called unearned income for children with assets and young adults in school. Students with large financial aid packages are finding their nontuition assistance for items such as room and board taxed by as much as 37 percent, even if their family income tax rates are much lower.
The impact on full-time undergraduate and graduate students under the age of 24 went largely unnoticed until the waning weeks of tax season. But word is spreading. About 1.3 million undergraduate students and 15,000 graduate students have scholarships and grant aid that cover nontuition expenses.
Ted Mitchell, the president of the American Council on Education, a Washington trade group representing 1,700 college and university presidents, wrote to Democratic and Republican leaders of the tax-writing House Ways and Means and Senate Finance Committees, urging them to “swiftly correct a mistake.”
Mr. Mitchell wrote that the portion of college scholarships subject to the tax is usually awarded to students from families of little means. Among those students are college athletes awarded full scholarships, many of whom come from economically disadvantaged backgrounds. “Now, those students are being taxed at the same rate as wealthy individuals,” Mr. Mitchell wrote.
The so-called kiddie tax rate was established specifically to address generational transfers used by rich parents to lower their tax burdens, but in the name of tax-code simplification, the Republican tax law expanded its reach. It is now hitting tribal funds dispensed to Native American children and young adults, and the families of service members who died in combat, some of whom saw hefty tax bills for their children’s survivor benefits this past spring.
A bipartisan effort, led by Representative Elaine Luria, Democrat of Virginia and a Navy veteran, would fix the tax law to classify survivor benefits as earned income.
“Democrats and Republicans agree — we must fix a broken system and ensure Gold Star families are not victims of a tax hike,” Ms. Luria said in a statement.
But a legislative fix to other targets is less far along. The kiddie tax expansion appears to be one of several unintended consequences of a tax law that Republicans rushed through Congress in less than two months — and a byproduct of conservatives’ desire to simplify the tax code and bring in new revenues to help offset the fiscal cost of cutting tax rates for individuals and businesses.
Congress originally established the tax in the bipartisan 1986 tax reform law, then tweaked it in a 2003 tax package passed under President George W. Bush. It forces children to pay taxes on both earned income — like salaries from summer jobs — and unearned income, like stock dividends and nontuition scholarships.
The different types of income have different rates, and until the Trump tax overhaul passed, the rate for unearned income was tied to how much a child’s parents earned. That meant scholarship winners from low-income families, whose parents had little or no federal income tax liability, also faced low tax rates.
The 2017 law evolved quickly as it sped through the House and the Senate. Almost from the start in the House, it included the change to kiddie tax rates for unearned income. When the Ways and Means Committee approved the tax-cut bill for a vote of the full House, Republicans included a report that said the bill “simplifies the ‘kiddie tax’ by effectively applying the rates applicable to trusts.”
While the change increased tax bills for some groups, it also effectively capped the amount of taxes for wealthy individuals.
The language was maintained in the Senate version of the bill, as well as the final agreement that Mr. Trump signed in December 2017.
Republicans now say they did not anticipate that it would raise taxes on low-income scholarship winners.
Jesse A. Solis, a Republican spokesman for the Ways and Means Committee, said that the 2017 tax law had achieved a long-sought goal of simplifying the tax code.
“When we first discovered that changes made to how unearned income for students is taxed was having unintended consequences on some college scholarships, we quickly went to work on solutions,” Mr. Solis said. “Discussions with the majority are ongoing, and we are hopeful that bipartisan action can be taken soon to provide greater certainty for students and their families.”
Senator Charles E. Grassley of Iowa, the chairman of the Senate Finance Committee, is working with his colleagues in the Senate and the House to address this issue as quickly as possible, according to a committee spokesman.
“Historically, after major tax legislation, the longstanding practice has been to correct drafting errors and other technical issues on a bipartisan basis,” Mr. Grassley said after reports of the Gold Star family tax increase came to light.
Democrats have expressed openness to fixing some other problems caused by the law, including harm to restaurant owners seeking to remodel their establishments. But after unanimously opposing the law, they are likely to demand a price for getting Republicans out of a political jam. Any fix would need to roll back some provisions of the law, Democrats say.
The new tax structure imposes a range of levies on unearned income: 10 percent on amounts up to $2,550, 24 percent on unearned income over $2,550, 35 percent on amounts over $9,150 and 37 percent on amounts over $12,500. According to the College Board, the average cost of room and board in the 2018-19 school year at a four-year public university is $11,140, and $12,680 at a private four-year school.
In the past, a student from a household with a joint income of $50,000 who was awarded a scholarship that covered $11,500 in room and board would be taxed at their parents’ rate of 12 percent. Under the new law, that money would be taxed up to 35 percent.
“It’s one of those things that is under the radar now but could really have a big impact,” said Megan McClean Coval, the vice president for policy and federal relations at the National Association of Student Financial Aid Administrators.
At the University of North Carolina at Chapel Hill, student aid officials said they had begun examining specific aid packages amid concerns about how the tax could affect its most needy students, said Rachelle Feldman, the university’s associate provost and director of scholarships and student aid.
About 14 percent of the university’s undergraduate class is part of a statewide program called the Carolina Covenant, which provides debt-free, full financial aid packages to students who fall 200 percent below the federal poverty level. That package includes nontuition room, board and living expenses that total about $13,402 in the university’s estimated cost of attendance next school year.
“Those expenses are real,” Ms. Feldman said. “Students need a place to live, they need food, they need toothpaste and toothbrushes. Anything that’s taxed from it is a stress.”