Stipend reported as Loan to be paid back by Future Service... Legit?

Question

My wife (as of '06) omitted a major portion of her salary for 2005 taxes, because it was received as a stipend as a fellow on an NIH training grant. Her university was not allowed to take out taxes, and up until April 2005 it was debateable whether NIH-NRSA postdoctoral trainees are subject to FICA and medicaire withholding (the IRS now says it is). So we just got a letter now telling us she is liable for taxes on an extra $45000 salary (apparently they haven't gotten to our 2006 taxes yet, since it will be the same for that year).
Apparently some of her co-fellows claimed (to tax authorities, on the advice of their employer) to receive the stipend as a loan, which they pay back with health-related service in the years after the loan.
We have until May 16 to get back to the IRS, and we are not sure what to do. She did not knowingly do anything wrong, and H&R Block did nothing to help us, even though they signed off on it... If we have to, we'll pay, but it's a lot of money...

Answer 1

The loan argument sounds fishy and you can easily check the terms of the fellowship to see if there is a repayment requirement (you know there isn't one). Even if there were a repayment requirement, only after you default on the agreement, and then repay the taxable income, would you be able to assert a claim of right to recover the taxes paid.

In fact, the money received from the NIH is taxable wages since there is a research or teaching requirement. If the grant money included funds used to purchase equipment, books, or travel, then you may be able to take deductions for that on Schedule A and reduce the taxes owed. See if an amendment that includes deductions for related costs doesn't help you. If not, then you will have to pay as figured by the IRS.

Answer 2

That is income in the year that it is received. The IRS treats "Prepaid Income" for future services as cash income in the year that it's received unless you are on an accural accounting method. Individual taxpayers are all considered cash basis so it's full taxable in the year of receipt. See this link: http://www.irs.gov/businesses/small/article/0,,id=117613,00.html

Answer 3

Because, some housing agencies consider any overage NOT used towards your educational expenses considered disposable income for outside sources. In other words, that money your getting, since not paying for your educaiton, you are using it outside of your costs, and thus, probably using it to pay bills or get other non educational items.