What Are the IRS Rules for Scholarship Funds?

Scholarship funds provide financial aid for educational pursuits and are often established as charities or foundations. To operate correctly, these organizations must adhere to specific Internal Revenue Service (IRS) rules. These regulations govern the initial setup of the program, the selection of recipients, and the use of the funds. Following these rules is necessary for an organization to maintain its tax-advantaged status and ensure that grants fulfill a genuine charitable mission.

Establishing a Qualifying Scholarship Program

For the IRS to recognize a scholarship program as a legitimate charitable activity, the fund must be organized and operated exclusively for charitable purposes, with the primary goal of advancing education. This means the organization’s activities must be directed toward a public benefit rather than a private interest. The legal structure of the fund is a determinant in its operational requirements. An organization can be structured as either a public charity or a private foundation, each with different rules affecting its scholarship activities.

Public charities generally receive a significant portion of their support from the general public or government and have more flexibility. They are not typically required to seek advance approval from the IRS for their scholarship procedures.

Private foundations, which are usually funded by a small number of donors, face more stringent regulations. A private foundation must request advance approval from the IRS for its scholarship-granting procedures to ensure the grants are not considered “taxable expenditures.” Failure to obtain this approval can result in significant penalties.

Objective and Nondiscriminatory Selection Process

A scholarship program’s selection process must be objective and nondiscriminatory to ensure grants are awarded for charitable reasons and not to serve private interests. The selection criteria must be related to the program’s mission and cannot be structured to favor a pre-selected group, such as the family members of the organization’s board.

The group of potential recipients must be a “sufficiently broad charitable class” to be considered a public benefit. For example, offering scholarships to all graduates of a particular high school would qualify, whereas limiting eligibility to one family’s children would not. The organization must also make a good-faith effort to publicize the scholarship opportunity to the entire eligible group.

To prevent conflicts of interest, the selection committee should be independent, especially when the fund has connections to a business. Committee members cannot be in a position to derive a private benefit from their selections. The process must be based on predetermined, objective criteria, such as academic merit, financial need, or other factors that align with the fund’s charitable purpose.

Rules for Employer-Sponsored Scholarship Funds

When a company establishes a scholarship fund for its employees or their children, the IRS applies additional scrutiny to distinguish legitimate scholarships from disguised compensation. The primary concern is that the program could be a way to provide tax-free payments to employees for their service instead of a genuine educational grant.

To address this, IRS Revenue Procedure 76-47 establishes a “facts and circumstances” test to evaluate the program’s objectivity. While mandatory for private foundations, public charities with employer-related scholarships are also encouraged to follow these rules.

The procedure includes percentage tests that provide a safe harbor. One test is met if scholarships awarded to employees’ children do not exceed 25% of the eligible applicants from that group. An alternative test is met if the grants awarded are 10% or less of the total number of all eligible employees’ children, regardless of whether they applied. These programs must also use an independent selection committee, free from the employer’s control, to ensure selections are based on established criteria.

Defining Qualified Scholarship Use and Recordkeeping

The tax treatment of a scholarship for the recipient depends on how the funds are used. For a scholarship to be entirely tax-free to the student, it must be a “qualified scholarship” as defined by the IRS. This means the money is used to pay for qualified education expenses at a qualifying educational institution. These expenses include:

• Tuition and fees required for enrollment
• Books required for courses
• Supplies required for courses
• Equipment required for courses

Conversely, any portion of a scholarship used for non-qualified expenses becomes taxable income for the recipient. Non-qualified expenses include costs such as room and board, travel, and optional equipment.

For its own compliance, the scholarship fund must maintain meticulous records to demonstrate adherence to all applicable IRS rules. These records include copies of all scholarship applications, minutes from selection committee meetings, the criteria used to choose recipients, and detailed financial records documenting the disbursement of all funds.