To start a tax-exempt scholarship fund, the IRS guidelines require you to form a properly organized entity under Section 501(c)(3), adopt governing documents containing specific charitable-purpose and dissolution language, apply for recognition of exemption on Form 1023 or Form 1023-EZ within 27 months of formation, follow objective and nondiscriminatory grant-selection procedures, and file an annual 990-series return every year after that. The details differ in important ways depending on whether the fund will be classified as a public charity or a private foundation, and that classification is the first decision to get right.
Public Charity or Private Foundation
Every 501(c)(3) organization is either a public charity or a private foundation, and the label follows the fund for its entire life. A public charity draws a substantial share of its support from the general public, government sources, or other publicly supported organizations, measured through a public support test over a five-year period; the fund generally needs more than one-third of its total support from public sources to pass.1Internal Revenue Service. Publicly Supported Charities2Internal Revenue Service. Exempt Organizations Annual Reporting Requirements – Form 990, Schedules A and B: Public Charity Support Test A fund backed primarily by a single family, individual, or company will typically be classified as a private foundation instead.
The classification matters most for donors and for how the fund must operate. Donors giving cash to a public charity can generally deduct up to 50 percent of adjusted gross income, with lower limits for appreciated property and a five-year carryforward for excess amounts. Cash gifts to a private foundation are capped at 30 percent of AGI, and long-term appreciated property tops out at 20 percent.3Internal Revenue Service. Charitable Contribution Deductions
Private foundations also carry heavier operational burdens. They must distribute at least 5 percent of the fair market value of their non-charitable-use assets each year as qualifying distributions.4Office of the Law Revision Counsel. 26 U.S. Code 4942 Miss that mark and the foundation faces a 30 percent excise tax on the shortfall, with an additional 100 percent tax if it isn’t corrected after IRS notification.5Internal Revenue Service. Taxes on Failure to Distribute Income – Private Foundations They also face tighter self-dealing rules and cannot award a single scholarship until the IRS approves their grant-making procedures in advance.
Governing Documents the IRS Requires
The IRS reviews your organizing document as a threshold test, and vague or missing language is the most common reason applications stall. Whether the fund is set up as a nonprofit corporation or a charitable trust, three provisions have to be there.
Charitable Purpose Clause
The articles must state that the organization exists exclusively for charitable and educational purposes as described in Section 501(c)(3).6Internal Revenue Service. Exemption Requirements – 501(c)(3) Organizations “To help students” is not enough. The clause should describe the provision of scholarships for educational purposes at qualifying educational institutions.
Dissolution Clause
If the fund ever dissolves, all remaining assets must go to another 501(c)(3) or to a federal, state, or local government for a public purpose.7Internal Revenue Service. Dissolution Provision Requirement Assets can never revert to founders, board members, or any private individual. Some states cover this by default, but stating it explicitly avoids ambiguity during review.
Prohibited Activities
The documents must bar private inurement: no part of the net earnings can benefit any private individual or insider.8Office of the Law Revision Counsel. 26 U.S. Code 501 The fund also cannot participate in any political campaign for or against a candidate and must substantially limit its lobbying.6Internal Revenue Service. Exemption Requirements – 501(c)(3) Organizations
Sign, date, and formally adopt these documents through the initial board or trustees before you file the application.
Filing for Recognition of Exemption
Before the exemption application, the fund needs an Employer Identification Number. You can apply online through the IRS or file Form SS-4; the online route issues the EIN immediately.9Internal Revenue Service. About Form SS-4
Form 1023 or Form 1023-EZ
The standard application is Form 1023, which requires detailed descriptions of planned activities, financial projections, officer information, compensation arrangements, and copies of the governing documents.10Internal Revenue Service. About Form 1023 A streamlined Form 1023-EZ is available only if the fund’s projected annual gross receipts will not exceed $50,000 in any of the next three years and its total assets will not exceed $250,000; the instructions include an eligibility worksheet you must complete first.11Internal Revenue Service. Instructions for Form 1023-EZ
Both forms are filed electronically through Pay.gov.12Internal Revenue Service. Applying for Tax Exempt Status The user fee is $600 for Form 1023 and $275 for Form 1023-EZ, both non-refundable and paid at filing.13Internal Revenue Service. Form 1023 and 1023-EZ User Fee Review of the full 1023 typically takes several months, and an IRS specialist may issue a development letter asking for clarification about governance or grant-making before making a determination.
The 27-Month Deadline
File Form 1023 or 1023-EZ within 27 months from the end of the month the fund was legally organized and, once approved, tax-exempt status is retroactive to the date of formation. File late and exemption is recognized only from the date the IRS receives the application.14Internal Revenue Service. Application/Notice Requirement Donations received during the uncovered gap are not deductible to donors, which can create serious problems with early fundraising.
Advance Approval of Grant Procedures for Private Foundations
A private foundation cannot award scholarships to individuals until the IRS approves its grant-making procedures in advance. Public charities have no equivalent requirement. Without advance approval, every scholarship grant a private foundation makes is treated as a “taxable expenditure” under IRC Section 4945, even if the recipient is deserving and the amount is reasonable.15Internal Revenue Service. IRC Section 4945(g) Individual Grants
The penalty stack is steep. The foundation faces an initial 10 percent excise tax on the amount of the taxable expenditure and an additional 100 percent tax if it isn’t corrected in time. Foundation managers who knowingly approve an unapproved grant face a personal 2.5 percent tax, rising to 50 percent if they refuse to correct.16Internal Revenue Service. IRC 4945 – Scholarship Grants to Individuals
To get approval, the foundation has to show the IRS three things: that its procedures award grants on an objective and nondiscriminatory basis, that they are designed to ensure grantees actually use the funds as intended, and that the foundation will supervise the grants and verify compliance with grant terms.17Internal Revenue Service. Advance Approval of Grant-Making Procedures The IRS evaluates the whole system, not each individual grant, and once approved the procedures carry forward to future programs as long as they do not materially change.
Selecting Recipients Without Triggering Self-Dealing
Every 501(c)(3) scholarship fund, public or private, needs a written policy defining who is eligible and how recipients are chosen. Acceptable criteria include academic merit, financial need, residence in a particular geographic area, enrollment at a specific type of institution, or pursuit of a particular field of study. Selection cannot be influenced by the personal interests of founders, directors, or major donors. The IRS strongly recommends using an independent selection committee that applies the criteria consistently.
For private foundations, awarding a scholarship to a “disqualified person” is generally treated as self-dealing and triggers excise taxes. Disqualified persons include substantial contributors, foundation managers, and their family members. A private foundation running a scholarship program for children of a company’s employees can avoid self-dealing treatment if it obtains an IRS ruling confirming the program qualifies under Section 117(a) and meets the conditions of the applicable revenue procedure.18eCFR. 26 CFR 143.2 – Taxes on Self-Dealing; Scholarship and Fellowship Grants
Employer-related programs also face a percentage test. The number of grants awarded to employees’ children in a given year generally cannot exceed 25 percent of the eligible applicants considered by the selection committee, or 10 percent of all eligible employees’ children. Exceeding those thresholds does not automatically disqualify the program, but it forfeits presumptive approval and forces a facts-and-circumstances review. Public charities running an employees’ children program have more flexibility, though the awards must still rest on objective standards and the benefit to the employee has to be incidental to the charitable purpose.
What Scholarship Money Is Tax-Free to Recipients
Not every scholarship dollar is tax-free. Under IRC Section 117, a scholarship is excluded from the recipient’s gross income only to the extent it covers qualified tuition and related expenses: tuition, fees required for enrollment, and books, supplies, and equipment required for courses of instruction at an eligible educational institution.19Office of the Law Revision Counsel. 26 USC 117 – Qualified Scholarships
Money spent on room and board, travel, or general living expenses is taxable to the recipient. So is any portion of the scholarship that represents payment for teaching or research services the student is required to perform as a condition of the grant. Restricting awards to tuition and required fees, or paying the institution directly, keeps compliance clean and protects recipients from unexpected tax bills. The fund should keep detailed records showing each scholarship went to qualified expenses and that the recipient was a degree candidate at an eligible institution.
If the fund plans to award scholarships to nonresident alien students, additional withholding applies. Taxable amounts are subject to a 30 percent federal withholding rate, dropping to 14 percent for students temporarily in the U.S. on F, J, M, or Q visas when the taxable amount is tied to a qualified scholarship, with possible further reductions under an applicable tax treaty.20Internal Revenue Service. Withholding on Scholarships Paid to Nonresident Aliens
Annual Filings and Keeping Exempt Status
Recognition of exemption is not a one-time achievement. The IRS requires an annual information return, and which form you file depends on classification and size.
- Form 990 for public charities with gross receipts of $200,000 or more, or total assets of $500,000 or more.
- Form 990-EZ for public charities with gross receipts under $200,000 and total assets under $500,000.
- Form 990-N (the e-Postcard) for organizations with gross receipts normally $50,000 or less.
- Form 990-PF for all private foundations, regardless of size.
Thresholds are based on the fiscal year’s financial activity.21Internal Revenue Service. Form 990 Series – Which Forms Do Exempt Organizations File
Miss the annual return three years in a row and the IRS automatically revokes the fund’s tax-exempt status. There is no warning letter and no grace period.22Internal Revenue Service. Automatic Revocation of Exemption Reinstatement means filing a new Form 1023 application and paying the associated fees again.23Internal Revenue Service. Automatic Reinstatement of Tax-Exempt Status Small funds relying on the e-Postcard are the most common casualties because the form is so simple that people forget it is mandatory.
The fund also has to give donors a written acknowledgment for any contribution of $250 or more, listing the organization’s name, the cash amount or a description of any non-cash contribution, and a statement about whether goods or services were provided in return.24Internal Revenue Service. Charitable Contributions: Written Acknowledgments Because most scholarship funds give nothing in return, the acknowledgment usually says so. Donors need the letter to claim their deduction.
State Registration Is Separate
Federal 501(c)(3) status does not satisfy state obligations. Most states require charitable organizations to register before soliciting donations from their residents, and many impose periodic financial reporting on top of that.25Internal Revenue Service. Charitable Solicitation – State Requirements Online fundraising can trigger registration in every state where donors are located, not just the fund’s home state. Some municipalities layer their own rules on top. Handle these registrations before you start asking for money.