501c3 Scholarship Rules According to the IRS

Public charities under section 501(c)(3) of the Internal Revenue Code can run scholarship programs as part of their charitable work. These programs must follow specific Internal Revenue Service (IRS) regulations to ensure they advance charitable purposes rather than serving private interests. Compliance with these rules is necessary for an organization to maintain its tax-exempt status, as the IRS governs how organizations define applicant pools, select recipients, and administer funds.

Defining the Eligible Applicant Pool

A 501(c)(3) organization’s scholarship program must serve a “charitable class,” which is the broad group of potential beneficiaries. This class must be sufficiently large or indefinite to ensure the program benefits the community rather than a predetermined group of individuals. The focus is on the breadth of the potential applicant pool before any selection begins.

An acceptable charitable class is defined in an open-ended way. For example, a scholarship for graduates of a particular high school, residents of a specific city, or students pursuing a degree in a field like nursing would qualify. These examples represent a large group where the ultimate beneficiaries are not individually identifiable from the outset.

Conversely, a charitable class that is too narrow will not meet IRS requirements. A program designed to benefit only the children of a single family or the employees of a specific, small company would be considered too restrictive. Such limitations suggest the program serves a private interest rather than a public one.

The IRS scrutinizes the charitable class to prevent donors from earmarking funds for specific individuals. A contribution is not a deductible charitable donation if the donor designates it for a particular person. This rule prevents using the charity as a pass-through for private gifts, so the organization must maintain ultimate control over selecting recipients.

Establishing an Objective Selection Process

After defining a valid charitable class, the organization must implement a fair and objective process for choosing recipients. This process involves the composition of the selection committee and the criteria used for evaluation. Private foundations may need to seek advance approval of their selection procedures from the IRS.

The selection committee must be independent to avoid conflicts of interest. Individuals who could derive a private benefit from the selection of grantees are prohibited from serving on the committee. This excludes the organization’s substantial contributors, board members, high-level employees, and their family members.

The criteria for selecting scholarship winners must be objective, nondiscriminatory, and established in advance. The organization must apply these standards consistently to all applicants. Acceptable objective criteria include:

• Past academic performance
• Test scores
• Community involvement
• Essays
• Recommendations

Prohibitions on Private Benefit and Inurement

A 501(c)(3) organization’s resources must not be used for private gain. The IRS distinguishes between private inurement and private benefit. Private inurement is a strict prohibition against any of the organization’s net earnings benefiting an “insider,” such as a director, officer, or their relatives. Any amount of inurement can jeopardize the organization’s tax-exempt status.

Private benefit is a broader concept prohibiting a substantial benefit to any private individual, insider or not. A private benefit may be permissible only if it is incidental to accomplishing a larger charitable purpose. For a scholarship program, this means the primary purpose must be charitable education.

Employer-related scholarship programs face scrutiny as they can be viewed as compensation rather than a charitable activity. The IRS established guidelines in Revenue Procedure 76-47 for when a company’s foundation offers scholarships to employees or their children. The program must not be an inducement for employment, and an independent committee must control the selection process using non-employment-related factors.

These guidelines also include percentage tests to determine if a program is charitable. For example, one test limits scholarships awarded to employees’ children to no more than 25% of the eligible applicants considered by the committee in a year. Another test limits awards to 10% of all eligible children, regardless of whether they applied.

Scholarship Administration and IRS Reporting

After selecting recipients, the organization must manage administrative and reporting duties. This includes the disbursement of funds and record-keeping. Organizations can pay scholarship funds to the educational institution or the student, but direct payment to the institution provides a clear record for educational use.

The organization must maintain comprehensive records to prove compliance during an IRS audit. Records should include all applications, the selection criteria, committee meeting minutes, evaluations of each applicant, and proof of payment for each scholarship. For employer-related programs, records must also show adherence to the specific IRS guidelines.

Scholarship program activities must be reported annually to the IRS on Form 990, Return of Organization Exempt From Income Tax. On the form’s Statement of Program Service Accomplishments, the organization must describe its activities and report the total number and amount of scholarships awarded.

If the organization provides grants to individuals, it may also need to complete Schedule I of Form 990, which requires more detail about the grants. Organizations that are schools must file Schedule E to report on their nondiscriminatory policies. Accurate reporting on Form 990 is part of demonstrating ongoing compliance.