Private foundations that want to have a scholarship program—and do the work of publicizing the program, reviewing applications, choosing winners, and monitoring awards—must get prior approval from the Internal Revenue Service. This one-time review ensures that you award scholarships (or other grants for study, travel, or similar purposes) in an objective, nondiscriminatory way. Without IRS approval and compliance with the IRS rules, your foundation will incur hefty excise taxes.
Note: While they must comply with certain IRS rules, grants to individuals for disaster relief, economic distress relief, or artistic achievement do not require prior IRS approval, nor do scholarships awarded through a third party, such as a community foundation or university. However, when awarded through a third party, the foundation can’t help choose the scholarship winners.
If your foundation is considering its own scholarship program, read on for regulations, tips, and resources to help:
- Consult your governing documents: If your articles of incorporation, bylaws, or trust documents prohibit grants to individuals, you must amend them or administer the scholarships through a third party.
- Understand IRS regulations: Before proceeding, understand that your scholarships must meet the following requirements:
- You can’t earmark scholarships for political, legislative, or other noncharitable activities.
- Scholarships cannot benefit foundation insiders, known as disqualified persons, including foundation managers, substantial contributors to the foundation, and family members of the aforementioned.
- Scholarships must be open to a charitable class, defined as a group large enough to allow an indefinite number of individuals to benefit.
- Your selection process must be objective and nondiscriminatory. The IRS allows gender-specific awards, but judges race-based criteria on a case-by-case basis.
Note: Corporate foundations can legally award scholarships to children of employees. The IRS requires that the scholarships benefit the students, not the corporation, and that the corporation follow other special rules.
Designing your scholarship program
Before seeking approval from the IRS, craft guidelines for your scholarship program and approve them at the board level. Legal counsel and an advisory committee can be helpful.
Keep your guidelines as flexible as possible to avoid limiting yourself down the road. For example, name broad fields of study, rather than specific majors, or the total award pool, rather than specific scholarship amounts.
Consider the following components, most of which the IRS wants to know:
- Eligibility: Describe the class of eligible recipients and any limitations on them.
- Award criteria: Many foundations use a combination of the following:
- Minimum SAT scores
- Graduate of a particular high school
- Student of a particular college/university or vocational/technical institute
- Particular class rank or academic performance
- Demonstrated talent or exceptional creativity
- Demonstrated financial need
- Participant in a particular sport or activity
- Particular field of study
- Motivation, character, or potential as demonstrated in an interview
- Selection committee: Describe who will select winners and their relation to the foundation.
- Amount: Rather than list specific grant amounts, simply list the total funds in the award pool.
- Publicity: Explain how you will inform candidates, such as via a simple website or by advertising through appropriate networks.
- Monitoring: Describe how you will monitor awards to ensure they serve their intended charitable purpose.
- Start date: When will the organization begin awarding scholarships? If they’ve already done so, list the recipients’ names and the amount received.
Getting IRS approval
IRS approval involves a one-time review to ensure that your foundation has in place an objective, nondiscriminatory selection process and procedures to ensure that winners comply with the scholarship’s terms.
Write a letter describing your intended procedures for selection and monitoring. If the foundation hears nothing from the IRS after 45 days, it can assume approval and begin awarding grants. If the foundation later learns that approval was denied, any scholarships awarded before the notice are not taxable expenditures, even if an installment is paid after the rejection notice.
Without IRS approval, private foundation scholarships are considered taxable expenditures, meaning that the foundation will be fined for violating IRS regulations.
Making and monitoring awards
With IRS approval in hand (or based on the 45-day rule), a foundation can begin the work of awarding and monitoring scholarships.
Private foundations must keep records that include the following for each scholarship winner:
- Name, address, and award amount
- The purpose for which the grant was given
- The criteria used to evaluate potential recipients
- Year-end grades and/or progress reports verified by the educational institution
- The relationship between the recipient and the foundation’s disqualified persons
Record this information annually and at the scholarship’s end. Save the information for three years after reporting the last installment on your Form 990-PF.
You also may need to file additional information returns if a portion of the grant is payment for room, board, travel expenses, or services rendered (e.g., research report).
If a grantee fails to submit the required reports, misuses funds, or no longer qualifies for the grant, the foundation must conduct an investigation. During that time, the foundation will stop payments until it receives assurance from the grantee that such actions will not occur again, takes reasonable steps to recover funds, or recovers funds before making any further payments.