IRS Rules for Scholarship Funds: Form 990 Reporting and Penalties

The IRS rules for scholarship funds turn on one question first: is your organization a public charity or a private foundation? Public charities can run a scholarship program with a reasonable selection process and annual reporting on Form 990. Private foundations must get their grant-making procedures approved by the IRS before making a single award to an individual, or the grant becomes a taxable expenditure that triggers excise taxes. On top of that, every fund has to define a broad enough pool of potential recipients, use objective criteria, refuse donor earmarks, handle withholding correctly for international students, and keep records that will still make sense to an examiner three years later.

Selecting Recipients: The Rules Every Fund Must Follow

A scholarship program must serve a genuine public purpose rather than funnel money to a handful of insiders. The IRS looks at whether the pool of potential recipients forms a sufficiently broad “charitable class.” All graduating seniors from a particular high school, or all students pursuing engineering degrees at accredited universities, would both qualify. A group defined as the children of five named donors would not.

Selection criteria should be objective and based on measurable factors: academic performance, financial need, a specific field of study. Vague or subjective standards invite scrutiny and can threaten the organization’s exempt status. Most well-run programs use an independent selection committee with no personal stake in the outcome.

A donor cannot earmark a contribution for a specific, pre-selected individual. This is one of the most common mistakes scholarship funds make. If a donor says “give this $10,000 to my neighbor’s daughter,” the organization must refuse the earmark. Accepting it converts the gift from a charitable contribution into a private benefit arrangement that can jeopardize exempt status for the entire organization.

Extra Rules That Apply Only to Private Foundations

Private foundations face substantially stricter requirements than public charities when awarding scholarships to individuals. Any grant from a private foundation to an individual for study, travel, or similar purposes is automatically treated as a “taxable expenditure” unless the foundation follows specific procedural safeguards.¹ A taxable expenditure triggers a 20% excise tax on the foundation, plus a 5% tax on any foundation manager who knowingly approved it.

Advance IRS Approval on Form 8940

To avoid that penalty, a private foundation must get its grant-making procedures approved by the IRS before making any awards to individuals.¹ The foundation submits Form 8940 with a detailed description of the selection criteria, the composition of the selection committee, and the procedures for monitoring how recipients use the funds.² A user fee is due at filing. If the IRS does not respond within 45 days, the procedures are deemed approved until the foundation hears otherwise.

Independent Committee, No Disqualified Persons

The selection committee must be independent of the foundation’s donors and managers. This is where many small family foundations run into trouble. If the founder’s spouse and two children are the only committee members, the IRS will reject the procedures. Outside educators, community leaders, or professionals with no financial connection to the foundation solve the problem.

Foundations must also avoid self-dealing with “disqualified persons.” That category includes substantial contributors, foundation managers, owners of more than 20% of a business that is a substantial contributor, and family members of any of those individuals.³ Family here means spouses, ancestors, children, grandchildren, great-grandchildren, and spouses of those descendants. Awarding a scholarship to the founder’s grandchild through the foundation’s own program would raise immediate self-dealing concerns.

Percentage Tests for Employer-Related Programs

Some private foundations run scholarship programs for employees or the children of employees at a particular company. These programs must satisfy percentage tests to prove the grants are not disguised compensation. For programs awarding grants to employees’ children, the number of awards in any year cannot exceed either:

25% of the employees’ children who were eligible, applied, and were considered by the committee; or
10% of the employees’ children who could be shown to be eligible, whether or not they applied.

For programs awarding grants directly to employees, the cap is 10% of employees who were eligible, applied, and were considered.⁴ Grant renewals from prior years do not count against the current year’s percentage.

Expenditure Responsibility

Even after IRS approval, the foundation must monitor how recipients spend the money. Recipients submit reports confirming the funds went toward the intended educational purpose. The foundation then reports to the IRS on each expenditure responsibility grant every year that any portion remains unspent, listing the grantee’s name and address, grant amount, amounts spent, and whether any funds were diverted. These reports are filed with the annual Form 990-PF.⁵

What the Recipient Is Taxed On

A scholarship or fellowship grant is excluded from the recipient’s gross income only when the recipient is a candidate for a degree at a qualifying educational institution and the money goes toward qualified tuition and related expenses: tuition, enrollment fees, and books, supplies, or equipment required for coursework.⁶ Amounts a student uses for room and board, travel, or optional equipment are taxable income to the student even if the scholarship covers them.⁷

Grants to individuals not pursuing a degree, such as recipients of professional development or certificate programs, are generally taxable in full regardless of how the money is spent.⁷

When a scholarship requires the recipient to teach, do research, or perform other services, the portion attributable to those services is taxable compensation and the paying institution reports it on a W-2 with income tax withholding.⁶ A common example is a teaching assistantship where part of the award covers tuition (excludable) and part compensates classroom duties (taxable).⁸ A narrow exception lets tuition reductions provided to graduate students who teach or do research for their university qualify for the tax-free exclusion.

Withholding and Reporting for International Students

Organizations awarding scholarships to nonresident alien students face separate withholding rules. The default federal withholding rate on taxable scholarship income paid to a nonresident alien is 30%. The rate drops to 14% when the recipient holds an F, J, M, or Q visa and the taxable amount is connected to a scholarship that would otherwise qualify for exclusion under Section 117.⁹ If a scholarship covers tuition plus a living stipend, the tuition portion stays tax-free and the stipend portion is subject to 14% withholding for students on qualifying visas.

Students from countries with U.S. tax treaties may claim full or partial exemption from withholding. Treaty eligibility depends on the specific country’s agreement, and each treaty sets its own time limits.¹⁰ Generally, only nonresidents can claim treaty benefits; once a student becomes a U.S. resident for tax purposes, the exemption typically expires.

Amounts paid to nonresident aliens are reported on Form 1042-S, not a 1099 or W-2. Form 1042-S must be filed with the IRS and furnished to the recipient by March 15 of the year following the payment.¹¹ There is no minimum dollar threshold; if the amount is taxable, it must be reported.

Annual Reporting: Form 990 or Form 990-PF

Public charities administering scholarship programs report grant activity on the annual Form 990. An organization that awarded more than $5,000 in total grants to domestic individuals during the year must complete Schedule I (Part III), which requires the aggregate number of recipients, the total cash amount granted, and a description of the type of assistance.¹² Part I of Schedule I asks the organization to confirm that it maintains records substantiating grant amounts, recipient eligibility, and selection criteria.¹³

Private foundations file Form 990-PF instead, which includes dedicated sections for individual grants and expenditure responsibility activities. Each expenditure responsibility grant must be individually reported for every year funds remain unspent.⁵

Do Not Use 1099-MISC or 1099-NEC

A common misconception is that taxable scholarship amounts used for room and board should be reported on a 1099-MISC or 1099-NEC. The IRS instructions for both forms say otherwise: do not use Form 1099-MISC to report scholarship or fellowship grants, and the same for Form 1099-NEC.¹⁴ Scholarship payments tied to services go on a W-2. Other taxable scholarship payments generally do not need to be reported by the payer on any form; the student is still responsible for including the taxable portion on their own return.

Penalties for Getting It Wrong

Late or Incomplete Annual Returns

An exempt organization that files its annual return late faces a penalty of $20 per day, up to the lesser of $10,000 or 5% of the organization’s gross receipts for that year.¹⁵ For organizations with annual gross receipts exceeding $1,000,000, the penalty rises to $100 per day, capped at $50,000. These statutory amounts are adjusted for inflation. The penalty also applies to returns that are filed but incomplete: turning in a Form 990 on time with Schedule I left blank when it should have been completed can still trigger the daily charge.

Automatic Revocation After Three Missed Years

An organization that fails to file its required annual return for three consecutive years automatically loses its tax-exempt status.¹⁶ Revocation is effective on the filing due date of the third missed return. The IRS has no authority to undo a proper automatic revocation, and there is no appeal. The organization must apply for reinstatement and receive a new determination letter before it can resume operating as a 501(c)(3).

Excise Taxes on Private Foundation Taxable Expenditures

For private foundations, the penalty for a grant that qualifies as a taxable expenditure is 20% of the grant amount paid by the foundation, plus 5% on any foundation manager who knowingly approved it.¹ A foundation that skipped the advance approval process can sometimes correct the problem after the fact by obtaining approval and showing that no grant funds were diverted, but that does not guarantee the tax will be eliminated.¹⁷

Records Worth Keeping

Every scholarship fund should maintain a paper trail that can withstand an IRS examination years later. At minimum: the original applications, the selection committee’s meeting minutes documenting how and why each recipient was chosen, proof that the committee was independent, and receipts or account statements showing the funds were disbursed for their intended educational purpose. Private foundations should add the grantee expenditure reports and a copy of the IRS advance approval letter for the grant-making procedures.

The organizations that get into trouble are usually not the ones making bad awards. They’re the ones that made reasonable awards and then couldn’t prove it when the IRS asked three years later.

1
Office of the Law Revision Counsel. 26 USC 4945 – Taxes on Taxable Expenditures
2
Internal Revenue Service. Instructions for Form 8940 (Rev December 2025)
3
Office of the Law Revision Counsel. 26 US Code 4946 – Definitions and Special Rules
4
Internal Revenue Service. Rev Proc 76-47, 1976-2 CB 670
5
Internal Revenue Service. Reports to the Internal Revenue Service – Expenditure Responsibility
6
Office of the Law Revision Counsel. 26 USC 117 – Qualified Scholarships
7
Internal Revenue Service. Topic No 421 – Scholarships, Fellowship Grants, and Other Grants
8
Internal Revenue Service. Publication 970 (2025) – Tax Benefits for Education
9
Internal Revenue Service. Withholding Federal Income Tax on Scholarships, Fellowships, and Grants Paid to Nonresident Aliens
10
Internal Revenue Service. Claiming Treaty Exemption for a Scholarship or Fellowship Grant
11
Internal Revenue Service. Instructions for Form 1042-S
12
Internal Revenue Service. Instructions for Schedule I (Form 990)
13
Internal Revenue Service. Schedule I (Form 990) (Rev December 2024)
14
Internal Revenue Service. Instructions for Forms 1099-MISC and 1099-NEC (04/2025)
15
Office of the Law Revision Counsel. 26 USC 6652 – Failure to File Certain Information Returns, Registration Statements, Etc
16
Internal Revenue Service. Automatic Revocation of Exemption
17
eCFR. 26 CFR 53.4945-1 – Taxes on Taxable Expenditures