A 501(c)(3) organization can run a scholarship program, but the 501(c)(3) scholarship rules require objective written selection criteria, grants structured to qualify as tax-free under Internal Revenue Code Section 117, and — for private foundations — advance IRS approval of the selection procedures before any award is made. Miss those requirements and the IRS can reclassify grants as taxable expenditures, impose excise taxes on the organization and its managers, or revoke exempt status.
Public Charity or Private Foundation
This classification drives nearly every other compliance obligation, so start here. Both public charities and private foundations can hold 501(c)(3) status, but the IRS regulates foundation scholarship programs much more tightly.
Public charities need objective selection criteria and solid records, but the IRC Section 4945 taxable-expenditure rules don’t apply to them. A community foundation or publicly supported educational charity operates under a meaningfully lighter framework than a private foundation doing the same work.
Private foundations must get advance IRS approval of their grant-making procedures before awarding scholarships to individuals. Without that approval, every payment is automatically treated as a taxable expenditure under IRC Section 4945, triggering excise taxes on the foundation and potentially on its managers.1Internal Revenue Service. Advance Approval of Grant-making Procedures
If you’re unsure which category applies to your organization, check the original IRS determination letter.
Advance Approval for Foundations
A private foundation requests approval by filing Form 8940 (Miscellaneous Determination Requests). The submission has to show that the selection process is objective and nondiscriminatory and that the foundation has adequate procedures for supervising how grant funds get spent. Approval covers the procedures the foundation described, so awards made outside that scope can still be treated as taxable expenditures even after approval is in hand.
Objective Selection Criteria
Every scholarship program needs clearly defined, written criteria for choosing recipients. For foundations, this is a condition of advance approval. For public charities, it’s how you demonstrate that the program serves a charitable purpose rather than channeling benefits to favored individuals.2Internal Revenue Service. IRC Section 4945(g) Individual Grants
Acceptable criteria typically include academic performance, demonstrated financial need, community involvement, or enrollment in a particular field of study. Criteria cannot hinge on personal relationships with the organization’s founders, board members, or major donors. Every applicant is measured against the same standards, and the organization should be able to show exactly why each recipient was chosen and each rejected applicant was not.
The IRS strongly favors an independent selection committee. Members should have no family or employment ties to the organization’s leadership, its major donors, or any applicant. Meeting minutes should document the review process and confirm that the published criteria drove every decision. That documentation becomes your primary evidence of compliance if the IRS examines the program.
Keeping the Scholarship Tax-Free for the Recipient
A scholarship is excluded from the recipient’s gross income only if it meets IRC Section 117. The recipient must be a candidate for a degree at an educational institution that maintains a regular faculty, a set curriculum, and a regularly enrolled student body. When that’s met, the recipient can exclude the portion used for qualified tuition and related expenses.3Office of the Law Revision Counsel. 26 US Code 117 – Qualified Scholarships
Qualified expenses include tuition, enrollment fees, and course-related costs like books, supplies, and equipment the student is required to have. Required student activity fees also count when the institution charges them to all students as a condition of enrollment. Optional fees don’t qualify.4Internal Revenue Service. Publication 970 – Tax Benefits for Education
Anything spent on room and board, travel, or other personal living costs is taxable to the recipient, even if the scholarship technically covers those amounts.5Internal Revenue Service. Topic No 421 – Scholarships, Fellowship Grants, and Other Grants The scholarship agreement should restrict fund use to qualified educational expenses, and the terms of the award should make that restriction enforceable.
Employer-Related Scholarships
Scholarships awarded to employees or their children draw intense IRS scrutiny because they look like disguised compensation. The IRS generally presumes these grants are taxable unless the program qualifies under Revenue Procedure 76-47.
The Percentage Test
Rev. Proc. 76-47 caps the number of awards each year. For scholarships to employees’ children, awards cannot exceed the greater of:
- 25% of employees’ children who were eligible, applied, and were considered by the selection committee that year, or
- 10% of employees’ children who can be shown to be eligible, whether or not they applied.
For scholarships awarded directly to employees, the cap is stricter: no more than 10% of employees who were eligible, applied, and were considered in that year.6Internal Revenue Service. Rev Proc 76-47 – Employer-Related Scholarship Programs The organization has to calculate these percentages annually. Exceeding the cap in a given year means grants to that category won’t automatically qualify as tax-free scholarships under Section 117.
The Facts and Circumstances Test
A program that can’t meet the numerical caps can still qualify if the IRS finds the primary purpose is genuinely educational rather than compensatory. The evaluation looks at the program’s history, funding source, how broadly it was advertised, the independence of the selection committee, the range of eligible fields of study, and whether grants are also available to non-employees or their children.
This is a harder path. Programs that limit eligibility to senior executives’ children, restrict studies to the employer’s industry, or require the student to work for the employer after graduation typically have trouble passing.
Penalties for Getting It Wrong
The penalty structure for private foundations is layered and unforgiving.
Taxable Expenditure Penalties
When a foundation makes an individual grant without approved procedures, or outside the scope of what was approved, the payment is a taxable expenditure under IRC Section 4945. The initial excise tax is 20% of the grant amount, paid by the foundation. Any foundation manager who knowingly approved the expenditure faces a separate 5% tax on the same amount.7Office of the Law Revision Counsel. 26 USC 4945 – Taxes on Taxable Expenditures
If the problem isn’t corrected within the taxable period, penalties escalate. The second-tier tax jumps to 100% of the expenditure on the foundation, plus 50% on any manager who refused to participate in correcting the violation. A $50,000 scholarship made without proper procedures could ultimately cost the foundation $85,000 in excise taxes on top of the grant itself.
Self-Dealing Penalties
Awarding a scholarship to a disqualified person can trigger separate self-dealing penalties under IRC Section 4941. Disqualified persons include the foundation’s substantial contributors, officers and directors, their family members, and entities they control. The initial tax on the disqualified person is 10% of the amount involved for each year the transaction remains uncorrected, plus 5% on any manager who knowingly participated.8Internal Revenue Service. Taxes on Self-Dealing – Private Foundations
If the transaction isn’t unwound during the taxable period, the disqualified person faces a 200% tax on the amount involved. The IRS cannot waive or reduce self-dealing taxes even when the person genuinely didn’t know the transaction was prohibited. That inflexibility catches a lot of family foundations off guard.
Reporting and Monitoring
Form 990 Disclosures
Organizations that distribute more than $5,000 in grants to domestic individuals must complete Schedule I of Form 990. Schedule I calls for a description of each type of assistance, the number of recipients, and total dollar amounts. Descriptions have to be specific: “scholarships for students attending a particular school,” not just “educational.”9Internal Revenue Service. Instructions for Schedule I (Form 990)
Grants to an interested person, such as an officer’s family member, generally do not need separate disclosure on Schedule L when the person received the grant as part of the broader class the program was designed to benefit and on the same terms as other recipients. Grants for travel, study, or similar purposes to interested persons must be reported on Schedule L, Part III.10Internal Revenue Service. Exempt Organizations Annual Reporting Requirements – Form 990, Part VI and Schedule L: Scholarships
Grant Monitoring for Foundations
Under IRC Section 4945(h), a private foundation exercising expenditure responsibility has to take reasonable steps to ensure each grant is used for its stated purpose, obtain reports from recipients on how the money was spent, and file detailed reports with the IRS. The depth of monitoring expected scales with the size and duration of the grant.11Internal Revenue Service. IRC Section 4945(h) – Expenditure Responsibility
In practice, that usually means requiring recipients to submit tuition receipts or grade reports at regular intervals and documenting the organization’s review. Foundations that write a check and move on are the ones that run into trouble during audits.
Records to Keep
The IRS requires exempt organizations to maintain books and records sufficient to demonstrate compliance with tax rules, including documentation supporting the annual return.12Internal Revenue Service. EO Operational Requirements: Recordkeeping Requirements for Exempt Organizations For scholarship programs, retain application materials, selection committee minutes, documentation of each recipient’s degree-candidate status, and proof that funds went to qualified expenses.
Scholarships to Nonresident Aliens
Awards to international students carry withholding obligations the domestic rules don’t reach. The standard federal income tax withholding rate on the taxable portion of scholarships paid to nonresident aliens is 30%. That rate drops to 14% when the recipient holds an F, J, M, or Q visa and the taxable amounts relate to a qualified scholarship under Section 117 or are paid by certain qualifying organizations.13Internal Revenue Service. Withholding Federal Income Tax on Scholarships, Fellowships and Grants Paid to Nonresident Aliens
The portion covering qualified tuition and required fees remains tax-free and exempt from withholding. Withholding applies only to the taxable portion, such as stipends for living expenses. Some tax treaties may reduce or eliminate withholding further, but the organization needs a Form W-8BEN from the student before applying any treaty benefit. Any amount that represents payment for services the student performs, such as teaching or research assistantships, is subject to graduated withholding based on Form W-4 instead of these flat rates.