501(c)(3) Scholarship Rules: IRS Approval and Reporting

A 501(c)(3) organization can run a scholarship program, but the IRS rules for 501(c)(3) scholarships require the money to pay only for tuition and required course materials, the recipients to be chosen by an independent committee using objective criteria, and — if the organization is a private foundation — the grant-making procedures to be approved by the IRS in advance. Public charities have more room to move; private foundations that skip advance approval turn every grant into a taxable expenditure under Section 4945.¹

What the Scholarship Money Can Pay For

Section 117 of the Internal Revenue Code sets the boundary. A scholarship is only “qualified” — meaning tax-free to the recipient and clearly within the organization’s exempt purpose — when it pays for tuition and fees required for enrollment, or for books, supplies, and equipment required for the student’s courses.²

Everything else sits outside the definition. Room and board, travel, and personal living costs are not qualified expenses even when the student incurs them because of enrollment. If a grant covers those items, that portion becomes taxable income to the student.

There is a second trap in Section 117(c). Any part of a scholarship paid as compensation for teaching, research, or other services the student is required to perform as a condition of the grant is not a qualified scholarship.³ A grant that funds a student’s tuition while they pursue their own research remains qualified. A grant conditioned on the student working as a lab research assistant does not; it reads as wages.

The recipient must attend an eligible educational institution, which generally means an accredited school with a regular faculty, curriculum, and enrolled student body. Community colleges, four-year universities, and accredited trade schools all count. If a program awards grants to students attending unaccredited programs, confirm the institution’s status first.

How Recipients Must Be Chosen

Written selection criteria, applied consistently to every applicant, are the foundation of any compliant program. Criteria typically rest on academic achievement, financial need, or pursuit of a particular field of study. Geographic limits are fine when they define a broad charitable class rather than a small circle of connected people.

An independent committee has to review applications and pick the recipients. Independence is what the IRS actually tests. Committee members cannot be the people who control the organization, the people who funded it, or their relatives, and they cannot be entities those individuals control.⁴ Anyone in a position to exercise substantial influence over the organization’s affairs is disqualified, and so are their family members.⁵

In practice, no committee member should vote on an application from their own child, a relative, or the child of an officer. Document who sits on the committee, and re-confirm their independence each grant cycle. A committee that looks independent on paper but takes direction from a major donor will not survive an IRS review of the foundation’s standards and procedures.⁶

Advance Approval for Private Foundations

Public charities can generally launch scholarship programs without pre-clearance. Private foundations cannot. Before a private foundation awards its first scholarship, it must obtain advance IRS approval of its grant-making procedures. Without approval, every individual grant is automatically a taxable expenditure under Section 4945(d)(3), no matter how carefully the program is run.⁷

The foundation has to demonstrate three things:

Grants are awarded on an objective and nondiscriminatory basis.
The procedures are designed to ensure grantees actually use the funds for their intended purpose.
The foundation will supervise grants to verify recipients meet the terms.⁶

Approval is a one-time process. Once the IRS accepts the system, it carries forward to future grant programs as long as the procedures do not change materially. The foundation files Form 8940 with a user fee. The current fee is set annually in the IRS Revenue Procedure at IRS.gov, or you can call 877-829-5500.⁸

Employer-Related Scholarship Programs

Programs that benefit employees of a particular company, or their children, draw the tightest scrutiny. The concern is obvious: an employer-funded foundation handing scholarships to workers’ kids can look like a tax-free fringe benefit dressed up as charity. To avoid taxable-expenditure treatment, these programs must meet the special standards in Revenue Procedure 76-47.⁹

The Percentage Tests

The program has to cap how many employee-connected recipients it awards each year. The IRS offers two alternative caps, and the foundation picks whichever it can meet:

Grants go to no more than 25% of the employees’ children who were eligible, applied, and were considered by the committee that year.
Grants go to no more than 10% of the employees’ children who can be shown to be eligible, whether or not they applied.¹⁰

When a program combines scholarships and educational loans for the same pool, the percentage tests apply to the total number of individuals receiving any type of grant. Failing the test reclassifies the grants as taxable expenditures and triggers excise tax on the foundation.

Independence From the Employer

The selection committee has to be independent of both the foundation and the employer, and no member can have the power to set the parent employees’ compensation. Selection criteria have to focus on the applicant’s own merit or financial need, not on the parent’s job title, seniority, or years of service. The employer should get no benefit from the program, and the scholarship cannot be an inducement to keep the employee at the company.⁴ The point is to separate the grant decision from the employment relationship.

Grants to International Students

Federal withholding applies when a 501(c)(3) awards a scholarship to a nonresident alien. The default rate on taxable U.S.-sourced scholarship income paid to a nonresident alien is 30%. The rate drops to 14%, or lower under a tax treaty, for students temporarily in the U.S. on an F, J, M, or Q visa, provided the taxable amounts relate to a qualified scholarship under Section 117(a). Any portion of the grant that compensates the student for services performed in the U.S. is subject instead to graduated withholding at regular income tax rates.¹¹ These payments are reported on Form 1042-S.¹²

Records and Annual Reporting

Solid records are what protect the program during an IRS examination. At a minimum, keep the written selection criteria and any changes to them, committee minutes with the reasoning for each award, documentation of each member’s independence, proof of enrollment at an eligible institution, and verification that grant funds were spent on qualified expenses — through direct payments to the school, receipts, or grantee expense reports.

Private foundations have to keep more. Case files on individual grants should include names, addresses, the purpose of each grant, how the recipient was chosen, and any relationship the recipient has to the organization’s officers, trustees, or donors.⁹

Form 990 With Schedule I

Most 501(c)(3) organizations report scholarship activity on Form 990 with Schedule I, which covers grants and assistance to individuals in the United States. Schedule I calls for specific descriptions of the type of assistance — for example, “scholarships for students attending a particular school” — rather than vague labels like “educational.” The form also asks whether the organization keeps records to substantiate grant amounts, recipient eligibility, and selection criteria, and it requires a narrative on how the organization monitors grants to ensure proper use.¹³

Form 990-PF for Private Foundations

Private foundations file Form 990-PF instead. The reporting is more detailed: the IRS expects individual grant information, not aggregate totals. These filings are public, so accurate reporting is both a tax matter and a transparency matter.

What Non-Compliance Costs

Under Section 4945(a), the first-tier excise tax on a taxable expenditure is 20% of the amount of the grant. A foundation manager who knowingly approved the expenditure also owes a separate personal tax.¹

In the scholarship context, a taxable expenditure usually comes from one of two failures: the foundation awarded grants without advance approval of its procedures, or it did not properly oversee how recipients used the money. The foundation is expected to make reasonable efforts to confirm funds are spent for their intended purpose, obtain complete reports from grantees, and file the required reports with the IRS.¹⁴

If the foundation does not correct the problem after the first-tier tax is assessed, a much larger second-tier tax applies. Repeated or egregious violations can lead the IRS to revoke the organization’s 501(c)(3) status, an outcome that is extremely difficult to reverse and ends the organization’s ability to receive tax-deductible contributions.

1
Office of the Law Revision Counsel. 26 U.S. Code 4945 – Taxes on Taxable Expenditures
2
Office of the Law Revision Counsel. 26 USC 117 – Qualified Scholarships
3
Office of the Law Revision Counsel. 26 U.S. Code 117 – Qualified Scholarships
4
Internal Revenue Service. Company Scholarship Programs
5
Internal Revenue Service. Disqualified Person – Intermediate Sanctions
6
Internal Revenue Service. Advance Approval of Grant-Making Procedures
7
eCFR. 26 CFR 53.4945-4 – Grants to Individuals
8
Internal Revenue Service. Instructions for Form 8940
9
Internal Revenue Service. Publication 4221-PF – Compliance Guide for 501(c)(3) Private Foundations
10
Internal Revenue Service. Taxable Expenditures by Private Foundations – Percentage Test – Employer-Related Educational Loans to Children of Employees
11
Internal Revenue Service. Withholding Federal Income Tax on Scholarships, Fellowships and Grants Paid to Nonresident Aliens
12
Internal Revenue Service. Instructions for Form 1042-S
13
Internal Revenue Service. Instructions for Schedule I (Form 990)
14
Internal Revenue Service. IRC Section 4945(h) – Expenditure Responsibility